Mexico - Second Agricultural Sector Adjustment Loan Project

Af J5 S 5 44L_- Document of The World Bank FOR OFFMCIAL USE ONLY Report No. P-5520-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A pROPOSED AGRICULTURAL SECTOR ADJUSTMENT LOAN II IN AN AMOUNT EQUIVALENT TO US$400 MILLION TO NACIONAL FINANCIERA S.N.C. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES MAY 29, 1991 Ths document bas a restricted distribution and may be used by recipieots only in the performance of teir official dutkes Its contents may not otberwise be disclosed witht World Bank authoriation.  CURRENCY UNIT - PESO (MEX$) On May 27, 1991, the exchange rate in the controlled market was US$1 = Mex$2988.2; and in the free market US$1 = Mex$3002.75. The controlled exchange rate is currently being devalued by four-tenths of a peso a day. FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES 1 hectare (ha) = 10,000 square meters (i2) 1 kilometer lkm) = 0.62 mile (mi) 1 square kilometer (km ) - 0.39 square miles = 100 ha 1 kilogram (kg) = 2,205 pounds (lbs) 1,000 kilograms = l metric ton (t) = 0.98 long ton 1 liter (1) = 2.26 gallons (gal)  FOR OFFICIAL USE ONLY PRNCPL AB TiOIS A AONMS USED AOSAL I Agrlcultural Sector Adjustment Loan I AOSAL IY Agricultural Sector Adjustment Loan SI ALSAMEX Altimentos Balanceados Mexicanos (Mexican Foodstuffs) ANAOSA Aseguradora Nacional Agricola (National Agricultural Insuranc- Agency) ANOSA Almacenes Nacionales de Doepsito (National Warehouses) AZUCAR Sugar Parastatal BANRURAL Banco Nacionol do Cr6dito Rural (National Rural Bank) BORUCONSA Bodegas Rurales CONASUPO (CONASUPO's Rural Warehouses) ccC United States Commodity Credit Corporation CFE Comtsi6n Federal de Electricidad (Federal Electricity CommissIon) CICOPLAFEST Intersecretarial Commission for the Control of Procesinlg and Use of Pesticides, Fertilizers and Toxic Substances CIF Cost, Insurance ond Freight CONAL ComisI6n Naclonal de Alimentaci6n (National Food CommissSon) CONADECA Comisi6n Nacional del Cacao (National Cocoa Commission) CONASUPO Compaeif Nacional de Substetencias Populares (National Food Supplies Company) DICCONSA Dietribuidora CONASUPO (CONASUPO Stores) DIF Programs do Deserrollo Integral do Is Familia (Program for the Integral Development of the Family) ENIaH Encuosta Noclonal de Ingresos y Gastoe de lon Hogares (National Household Income and Expenditure Survey) ESL Fxport Sector Loan FERTIMEX Fortilizantes Mexicanos (Mexican Fertilizers) FIRA Fideicomisos Instituidos en Relacion con Is Agricultura (Trust Funds for Agriculture) FOB Free on Board anP Gross Domestic Product GNP Gross National Product 0OM Government of Mexico ICONSA Industrias CONASUPO (COHASUPO Industries) IDB Inter-American Development Bank INCO Instituto Nacional del Consumidor (National Consumer In* ttute) INMECAFE Instituto Mexicano del Caf6 (Mexican Coffee Institute) IMF International Monetary Fund ZUSS Instituto Mexicano del Seguro Social (Mexiean Institute for Social Security) INIFAP Instituto Nacional de Investigaciones Forestales, Agrlcolas y Pecuarlas (Agricultural R"earch Institute) ISPL Industrial Sector Pollcy Loan LICONSA Loche Industrializada CONASUPO (CONASUPO's Industrialized Milk Subsidiary ) NAFIN Nacional Financiert, S.N.C. PACTO Economic Solidarity Pact PASSPA Programs de Apoyo de los Servicios do Salud para la Poblocl6n Abierta (Health Services Support Program for the Uninsured Population) PRONAL Progroma Nasional de Alimentaci6n (National Food Program) PRONASE Productora Nacional de Semilla (National Seeds Producer) PRONASOL Programa Nacional de Solidaridad (National Solidarity Program) PECE Pacto pars ts Estibilizacion y et Crecimiento Economico (Pact for Stabilization and Growth) QRs quantitative Restrictions SARN Secretaria de Agricultura y Recursos Hidraulicos (Ministry of Agriculture and Hydraulic Resources SECOFI Secretaria de Comercio y Fomento Industrial (Ministry of Trade and Industrial Development) SEDUE Socretaria de Desarrollo Urbano y Ecologia (Ministry of Urban Development and the Environment) SHCP Secretaria de Hacienda y Credito Publico (Ministry of Finance and Public Credit) SQE Statement of Expenditures SPP Secretaria do Programacion y Presupuesto (Ministry of Budget and Planning) SSA Secretaris de Salud y Asistencia (Ministry of Health) TABAMEX Tabacos Mexicanos (Mexican Tobaccos) TPL I First Trade Policy Loan TPL II Second Trade Policy Loan TRICONSA Trigo Industrializado CONASUPO (CONASUPO's Industrialized Wheat) This documnent has a restricted distribution and may be used by recipients only in the perfornmw.ce of their official duties. Its contents may not otherwise be disclosed without World Bank - -zation.  MEXICO AGRICULTURAL SECTOR ADJUSTMENT LOAN LOAN AND PROGRAM SUMMARY Borrower and Nacional Financiera S.N.C. (NAFIN) Beneficiaryt Guarantor: United Mexican States Executing Asency: Secretaria de Hacienda y Credito P(iblico (SHCP) through Secretaria de Agricultura y Recursos Hidraulicos (SARH), Secretaria de Comercio y Fomento Industrial (SECOFI), Secretaria de Programacifn y Presupuesto (SPP), and Health System [Secretaria de Salud y Asistencia (SSA) and other entities of the health system] Amount_ US$400 million equivalent Termss Repayment in 17 years, including five years of grace, at the standard variable rate. Obiectives: The AGSAL II is part of a program of Bank support to the government's objectives of increasing the rate of growth of agriculture, raising productivity and improving the efficiency of the agricultural sector through better- functioning output and input markets, and alleviating the poverty of the most vulnerable population groups through targeted food programs. This loan would support: (a) trade and policy reforms that increase competition and reduce the government's role in the production, planning, marketing, storage and processing of agricultural products and inputs, and by allowing more competition from the private sector; (b) revision in the allocation of government expenditure in consumer programs by eliminating generalized food subsidies and increasing spending for improved targeted food assistance and nutrition programs; and (c) the institutional transition of SARH to a smaller but more effective role in agriculture, emphasizing policy formulation and implementation and basic regulatory functions. Description: The program includes measures to reform the price and trade policy regime for agricultural products and their industrial derivatives, abolish the system of mandatory production planning for agricultural products, reduce and streamline market regulations and barriers to entry and competition, and make food consumption and nutrition programs more cost effective and successful by increasing coverage and improving targeting of the poorer population. Benefits and If the objectives outlined above are achieved, then the Risks: benefits accruing from the project may be significant. Continuing liberalization of agricultural trade and prices and streamlining of the regulatory environment will contribute to expand agricultural production and better resource allocation, improve real income and generate a better nutrition and health status for the poor. There are  - ii - few risks to this program. The government has carried through its program of trade, deregulation and gradual price liberalization as part nf the broader program of stabilization and structural reform over the past five years. Risks may be twofold. First, one important lesson of economic history is that the macroeconomic climate must be supportive of policy reforms. The key requirements are fiscal discipline, a prudent monetary policy and a realistic exchange rate. Second, the very purpose of agricultural policy reform is to encourage improved resource allocation. Changes in pattern of resource use are resisted by those who benefit from the status quo. If governments do not resolutely follow through with credible policy change, the momentum for reform may be lost and the program endangered. Over the past five years the Mexican record of overall policy reform has been strong. The risks seem manageable and are outweighed by the likely benefits of AGSAL II. Disbursements: The proceeds of the loan will be used to finance eligible import expenditures, and statements of expenditures (SOEs) will be used as a basis for the preparation of the disbursement requests. The first tranche would become available upon loan effectiveness, expected in July 1991, and the second tranche, expected in August 1992, on fulfillment of specific conditions related to progress in implementing the program and general conditions on macroeconomic consistency and satisfactory execution of the program. Appraisal Report: This is a combined Staff Appraisal and President's Report. Schedule of Disbursementst Schedule of Disbursements Bank Fiscal Year FY92 FY93 First Tranche 200 _ Second Tranche - 200 Cumulative 200 400  mXco AGRICULTURAL SECTOR ADJUSTMENT LOAN II TABLE OF CONTENTS Page No. LOAN AND PROGRAM SUMMARY . . . . . . . . . . . . . . . . . . . . . . .i-i PART I. THE MACROECONOMIC CONTEXT .... .... . 1 A. Macroeconomic Developments . . . . . . . . . . . . . . .2 B. The Debt Restructuring Package of 1989/90 . . . . . . . . 3 C. Oil Prices and the Macroeconomic Situation . . . . . . . 4 D. The Real Exchange Rate .... . . . . . . . . . . .. 4 E. Fiscal Consistency, Debt Management and the Stabilization Program .... . . .5..... . . . . . S P. The Pacto/PECE and the Decline in Inflation since 1987 . 7 G. Medium-Term Finance for Growth . . . . . . . . . . . . . 8 H. External Debt and Creditworthiness . . . . . . . . . . . 9 PART II. THE SECTORAL CONTEXT . . . . . . . . . . . . . . . . . . . . 10 A. Introduction . . . . . . . . . . . . . . . . . 10 B. Policy Issues for Agricultural Growth and Productivity . 11 1. Price, Trade Policy and Market Regulations . . . . . 11 a. Background and Actions Taken . . . . . . . . . . 11 b. Proposed Actions . . . . * ...... ... . . . 18 2. SARH's Production Targets . . . . . . . . . . . . . 22 3. Government Expenditure . . . . . . . . . . . . . . . 23 a. Credit and Input Subsidies . . . . . . . . . . . 23 b. Investment Expenditure . . . . . . . . . . . . . 24 C. Food Consumption and Nutrition . . . . . . . . . . . . 24 1. Introduction .... . . . . . . . . . . . . . .. .24 2. A New Food Consumption and Nutrition Strategy . . . 26 a. Elements Already in Place . . . . . . . . . . . 26 b. Key Elements of the Long-Term Strategy . . . . . 27 c. Constraints and Transition . . . . . . . . . . . 29 d. Pilot Nutrition and Health Project . . . . . . . 29 e. Maize Consumption Policy . . . . . . . . . . . . 30  -ii - Page No. PART IIT. GO'ERNMENT AND BANK STRATEGIES . . . . . . . .. . . 32 A. Government Strategy . . . . . . . . . . . . . . . . . 32 B. Bank Assistance Strategy . . . . . . . .. .... 33 C. Sectoral Composition of Bank Lending . . . . . . . . 34 D. Poverty, the Social Sectors, and the Environment . . 36 E. Collaboration with IFC . . . . . . . . . . . . *. .. 37 PART IV. THE PROPOSED LOAN . . . . . . . . . . . . . . . . . . . . 37 A. Rationale tor AGSAL II . . . . . . . . . . . . . . . . 37 B. Amount and Loan Objectives . . . . . . . . . . . . . . 38 C. The Borrower, the Guarantor and Disbursements . . . . 38 D. Procurement and Financial Management and Auditing . . 39 E. Benefits and Risks . . . . . . . . . . . . . . . . 39 F. Cofinancing . . . . . . . . . . . . . . . . . 40 G. Negotiations, Effectiveness, Dated Covenants and Second Tranche Release Conditions . . . . . . . . . 40 PART V. COLLABORATION WITH THE IMF . . . . . . . . . . . . . . . 43 PART VI. RECOMMENDATION . . . . . . . . . . . . . . . . . . . . . 43 ANNEX 1. MACROECONOMIC INDICATORS . . . . . . . . . . . . . . . . 44 ANNEX 2. STATUS OF BANK GROUP OPERATIONS IN MEXICO . . . . . . . . 46 ANNEX 3. POLICY LETTER . . . . . . . . . . . . . . . . . . . . . . 48 ANNEX 4. POLICY MATRIX . . . . . . . . . . . . . . . . . . . . . . 83 ANNEX 5. RECENT POLICY REFORMS IN AGRICULTURAL COMMODITY MARKETS AND PARASTATALS . . . . . . . . . . . . . . . . . . . . 92 A. Price and Trade Policy . . . . . . . . . . . . . . . . 92 B. Parastatals . . . . . . . . . . . . . . . . . . . . . 94 ANNEX 6. FOOD CONSUMTION PROGRAMS . . . . . . . . . . . . . . . . 95 A. Programs . . . . . . . . . . . . . . . . . . . . . 95 B. Brief Assessment of Targeted Programs . . . . . . . . 100 ANNEX 7. SUPPLEMENTARY LOAN DATA SHEET . . . . . . . . . . . . . . 103 MAPs IBRD 20343  ZNTEMRJZONAL RANK TOR RECONSTRUCTION AND DJ iLOPnTi REPORT AND RI COIUNDATZONS OF TUE PRESWENT TO TME UXUCUTIVE DIRECTORS ON PROPOSED SECOND AGRICULTURAL SECTOR ADJUSTUNUT LOAN TO NACIONAL FINANCIERA S.N.C. ("AFix) I submit the following report and recommendation on a proposed loan to Nacional Financiera S.N.C. (NAPINSA), with the guarantee of the United Mexican States, for the equivalent of US$400 million in support of a program for agricultural sector reform. The loan will have a term of 17 years, including 5 years of grace, at the standard variable interest rate. PAR? I -TE MACROECONOMIC CONTExT 1. Beginning with the economic crisis of 1982 and particularly since 1985, the Mexican government has been implementing a strong program of economic stabilization and structural adjustment that has been supported by the international financial community. The strategy of relying on protectionism and public sector-led growth has been abandoned in favor of promoting international competitiveness and private sector expansion. since mid-1985 the cornerstone of the structural reforms has been far-reaching trade liberalization, which in turn has promoted expansion and efficiency of the tradable sector. The World Bank has supported trade policy reform with the Trade Policy Loan I (TPL I) in July 1986 and the Trade Policy Loan II (TPL II) in October 1987, each of US$500 million. In June 1989 the Board approved three loans of US$500 million each to support adjustment programs in the financial, public enterprise, and industrial sectors. In December 1989 the Bank approved an interest-support loan of US$1.26 billion to support the government's debt reduction plan and in June 5, 1990 an adjustment loan of US$380 million to support policy reforms in the transportation and telecommunications sectors. 2. The Bank has maintained a close dialogue with the government on agricultural and food policy and has supported the adjustment process with the Agricultural Sector Loan I (AGSAL I) for US$300 million approved in March 1988. As a follow up to AGSAL I, the proposed Agricultural Sector Adjustment Loan II (AGSAL II) would support reforms ins (a) price and trade policy in agricultural output and inputs; (b) regulation in the production and distribution of agricultural commodities and their industrial derivatives; and (c) food consumption and nutrition policy. 3. AGSAL II will support measures that fit in well with the government's development strategy. With the stabilization program consolidated successfully and the debt issue resolved, eccarmic policy will shift toward the attainment of high and sustainable rates of growth and to issues of poverty alleviation. These objectives will be furthered by continued liberalization of Mexican agricultural markets and improved productive efficiency as well as by reforms in trade and price policy, government expenditure, and the regulatory environment. Poverty alleviation will be improved by better targeting of food and nutrition programs to poor  - 2 - and vulnerable households, especially in rural areas. Overall, increasing the freedom to produce and trade in agricultural commodities will provide a strong engine for agricultural growth. A. Macroeconomic Developments 4. Between 1950 and 1974, Mexico enjoyed high growth, low inflation, and moderate external debt accumulation. Real growth averaged 6.4 percent, and inflation was in single digits. This era came to an abrupt end in the early 1970s. Government involvement in the economy expanded rapidly, and increased public expenditure pushed up aggregate demand and the rate of economic growth. However, the higher government expenditure was not matched by rising public sector revenues. As a result, the inflation tax and external debt became increasingly important sources of public finance. At the same time a decline in savings incentives (real Interest rates turned sharply downward) prevented a matching increase in private savings; external debt thus increased, increased oil revenues notwithstanding. The period of single-digit inflation ended in 1973, the peso started to appreciate in real terms, and external debt accelerated above the GNP growth rate. A comparatively brief crisis in 1976 terminated after major oil discc eries in 1977. The ensuing prosperity lasted until 1982, when falling international oil prices, rising world interest rates, and massive capital flight led to a refusal by external creditors to roll over Mexico's short-term debt. This led to Mexico's suspending interest payments on its external debt. 5. The financial and economic crisis of 1982 brought on explosive inflationary and balance of payments difficulties. Initial strong fiscal and monetary adjustment efforts were undermined by external shocks such as the collapse of international oil prices in 1986. Inflation accelerated, partially in response to the sharp real devaluation of the exchange rate necessitated by the 1986 downturn in the terms of trade. The subsequent de facto targeting of the real exchange rate 1/, together with frequent wage and cost adjustments, created instability in the system, culminating in a run on the peso in the last quarter of 1987 and triple-digit inflation. 6. The government responded in 1987 with the Economic Solidarity Pact (Pacto), an agreement among business, labor, and government that called for accelerated structural reform, further tightening of fiscal and monetary policy, a freeze of minimum wages and of basic public and private sector prices, and, the cornerstone of Pacto, a freeze of the nominal exchange rate against the U.S. dollar. This partial freeze was extended at three-month intervals through 1988 and was renewed in late 1988, with some modifications, by the new Mexican administration. The main change under this renamed Pact for Stabilization and Growth (PECE) was the daily adjustment of the exchange rate--of one Mex$ peso against the U.S. dollar, later lowered to Mex$0.8 pesos and, most recently, to Mex$0.4 pesos per day. (PECE was recently extended through 1991.) The fiscal measures, backed by the temporary exchange rate freeze and an array of formal and informal wage and price controls, have ;/ The real exchange rate is defined as the price of foreign goods relative to domestic goods. Appreciation thus implies a decline in this relative price.  - 3 - been dramatic in reducing the rate of inflation--from 159 percent in 1987 to 30 percent in 1990. 7. Throughout this period of macroeconomic turmoil, Mexico has been transforming itself into one of the most open economies in the world, through extensive trade reform. Trade liberalization, mostly between 1985 and 1988, has lowered the percentage of domestic (non-oil) tradeable production covered by import quotas from 100 percent in 1984 to less than 15 percent at present. Maximum import tariffs were cut by a similar magnitude. Non-oil merchandise exports, which represented less than one-third of total exports in 1984, have doubled their share since then. 8. These "core" reforms have been complemented by many others. In May 1989, foreign investment regulations were considerably relaxed and made more transparent. The tax system underwent a series of reforms, bringing marginal tax rates more in line with the levels in major industrial countries, encouraging the repatriation of flight capital, and increasing the sanctions for tax evasion. The impact of inflation on the (corporate) tax system was eliminated by removing purely inflationary gains from the tax base. The government initiated a parallel process of financial market liberalization, abolishing ceilings on commercial banks' deposit interest rates, forcing allocation of commercial credit toward favored sectors, and reducing credit subsidies granted through official development banks. Recently, it was announced that privatization of commercial banks, which were nationalized in 1982, would take place. B. The-Debt Restructuring Package of 1989190 9. Despite Mexico's far-reaching reforms, international capital markets did not provide the resources to bridge the difficult period when the current costs of the economic reform program were not yet matched by the (future) benefits of the program. The uncertainty caused by future transfer problems--through the impact of transfers on the perceived sustainability of the exchange rate regime and from there to domestic real interest rates--thus directly threatened the survival of the stabilization program and the restoration of economic growth. Therefore, in 1988, the government initiated negotiationo to restructure its external debt. 10. On September 15, 1989, the Government of Mexico and the Bank Advisory Committee representing commercial bank creditors agreed to a financing package to cover 1989-92, thereby restructuring USS48.9 billion of Mexico's external debt. The agreement's menu of financing options included two debt and debt service reduction facilities and four new money facilities, which were implemented over eight months. A total of US$22.8 billion was exchanged for par bonds at a fixed rate of 6.25 percent, and US$19.8 billion for discount bonds at market rates, but with the principal reduced by 35 percent. 11. The debt relief package reduced by almost US$4 billion per year the net transfer that Mexico must make to its creditors from 1989 to 1994. This is on average slightly below 2 percent of GDP. Half this amount results from the lengthening of maturity implied by the deal, with the rest coming from lower interest payments and new money disbursements from banks that did not  - 4 - choose the debt service reduction options. The reduction in required external transfers has a direct beneficial impact on Mexico's fiscal situation and its likely output growth. However, at least as important have been the indirect, secondary effects of renewed confidence. Reduced net external transfers mean reduced pressure on the exchange rate, which greatly reduces the risk associated with peso-denominated public sector debt. Nominal interest rates fell from 56 percent to around 36 percent immediately after the details of the package became known and fell a further 12 points to about 25 percent in early 1991. At the same time, the maturity structure of public debt has lengthened considerably, another indication of private confidence. C. Oil Prices and the Macroecon2Mi. Situation 12. In 1990, just as Mexico was looking forward to a feasible although somewhat precarious economic recovery, the entire short-term outlook changed because of events in the Middle East. The Gulf crisis clearly boosted Mexico's oil revenue in the last four months of 1990. But the increased volatility of oil markets since late-August has increased the uncertainty about Mexico's future balance of payments and hence has complicated macroeconomic management. Because of anticipated disruption in the oil supply, the benchmark West Texas intermediate oil price--US$16 per barrel as recently as last July--shot up to more than US$37 pb in October 1990. Mexico's oil price responds to this benchmark after about a one-month lag, with a typical negative price difference of around US$3.50 (changes in Mexico's export mix may affect this difference). After the Gulf war started in January 1991, however, the West Texas oil price dropped to around US$21 pb. There is a possibility that oil prices may fall substantially below current levels now that the war is ended. This illustrates how uncertain Mexico's oil export prospects remain, and in fact, at current oil prices the value of Mexican oil exports in 1991 will be lower than in 1990. The Mexican Government has therefore wisely devoted the entire windfall gain to the repurchase of public debt and has submitted a budget to congress based on this strategy (the budget assumes that the oil price will be US$17 per barrel, on average, for 1991). D. The Real Exchange Rate 13. Exchange rate policy in Mexico is complicated because the nominal exchange rate remains an important ingredient of PECZ. But with price and wage rigidities still prevalent--also because of PECE--the nominal exchange rate policy cannot be separated from real exchange rate developments. 14. Mexico's real exchange rate shows a somewhat ambiguous trend (see Figure 1). Measured against U.S. wholesale prices, much of the increase in competitiveness that occurred during the 1986-87 real depreciation has been lost; however, the economy is now back where it was around 1984-85, with competitiveness improved by about 36 percent over the clearly unsustainable level of 1981. 15. Since 1981, the real price of oil has dropped by almost 30 percent, trade barriers have been reduced, and government expenditure (most of which is for Mexican goods) has been reduced drastically. These changes would call for a real depreciation, although it is hard to judge whether 30 percent against U.S. producers is enough. There is some additional reason for concern (see second line in Fig. 1) in terms of competitiveness as measured not  - 5 - against U.S. producers, but against other countries exporting to the U.S. (note the use of the U.S. import unit value as the foreign price index). Since other exporters by and large Figure I have not followed the U.S. dollar up-- but followed It down--Mexico's increase in competitiveness in the MElC. REL ECHANGE RATE early 1980s was smaller, but its Of MW kWrIs. A* 1@a) subsequent loss of competitiveness was 1A - k not. The net result is that, measured w , x against other exporters to the U.S., *-r Mexico is 24 percent more competitive now than it was in 1981 and only 12 percent more competitive than in 1980. 16. Attaching much weight to b_ SW such trends demands caution. Structural. changes in Mexico and in its export markets, changes in macroeconomic policy both abroad and in Mexico, and so on, limit the relevance of the past real exchange rate for an assessment of current competitiveness. In the first half of 1990 there was a legitimate reason for concern: the strong expansion in private demand that is behind Mexico's widening trade deficit did not seem to translate into increased demand for Mexican goods since GDP growth slowed to below 2 percent. This could have signaled an overvaluation of the real exchange rate, especially since manufactured exports also slowed down significantly. If increased aggregate demand does not spill over to increased sales of Mexican goods, it could be that these goods are too expensive, i.e. that the real exchange rate is overvalued. However, more recent data do not support such an interpretation. Manufactured exports strongly recovered in the third quarter of 1990 and in the first two months of the fourth quarter by more than 20 percent. GDP growth recovered as well, up to 5.5 percent in the third quarter and, on a preliminary basis, 5 percent in the last quarter of 1990. Strong export sales and increased sales of Mexican non-oil goods (i.e high GDP growth) do not support an interpretation of overvaluation of tne real exchange rate. 17. Of course third- and fourth-quarter data may be misleading in that they indicate a temporary surge rather than a return to a trend. Thus, continued monitoring will be important. In this context, it should be noted that Mexico is about to enter the third year of an Extended Fund Facility (EFF) with the IMF; under that program the exchange rate and more external competitiveness are key variables being monitored on a quarterly basis. S. Fiscal Consistencv. Debt Manacement. and the Stabilization Prooram 18. Previous sections concluded that Mexico is likely to achieve satisfactory output growth over the years, depending on whether supportive macroeconomic policies are in place and if private sector development materializes. So that entrepreneurs will be convinced that the favorable current environment is permanent, the credibility of the government's program is an essential precondition for a private sector-led investment program to succeed.  - 6 - 19. Very little is known about what establishes macroeconomic credibility, but a great deal is known about what will destroy it. In particular, inconsistency is at the core of many recent stabilization failures--between on the one hand, fiscal policy, solvency constraints on the debt issue, and the resulting need for monetization and, on the other hand, announced inflation targets, possibly embedded in an exchange rate rule. Figure 2 summarizes the basic facts about fiscal deficits in Mexico. It shows the primary and the operational surplus (a negative number indicates a deficit) of the consolidated government, including all non-financial state enterprises and the Bank of Mexico. The primary surplus is the most fundamental indicator in that it measures the net transfer the government makes with respect to all non-public agents in the economy. Subtracting all interest paid on foreign debt and real interest payments on domestic debt (shaded area) leads to the operational surplus. 20. The figure highlights two important points. First, Mexico's fiscal adjustment over the past decade has been extraordinaryi its primary balance turned from a deficit of 7 percent of GDP into a surplus of around 5 percent in the mid-1980s. This surplus further increased to between 7 and 8 percent of GDP in the last couple of years. The period over which the adjustment has been sustained is as impressive as its extent. The second point has to do with the extreme volatility of interest payments on domestic debt. While interest payments on foreign debt have not varied much, except for the break caused by last year's debt deal, domestic interest payments rose from basically zero in real terms (1987) to around 6 percent of GDP by 1989 and fell to 2-3 percent of GDP in 1990. 21. It is clear that Mexico's "heterodox" stabilization program was the final phase of a long-running, initially entirely orthodox effort to Figure 2 reduce inflation through fiscal restraint alone. When success did and Interest Payments not result from the fiscal effort, Deficits (nOfP) however, and when inflation accelerated in late-1987, the Pacto with all its unorthodox components was put in place. The first question a this experience suggests is how much fiscal adjustment is enough? Mexico's adjustment has been -t substantial, but was it enough, given s the ambitious goal of eventually reaching single-digit inflation? _______________-_______-_o. ____ 22. A fiscal stance that does not conflict with sustained low inflation, even in the event of unfavorable external developments and continued high real interest rates, is clearly necessary--although possibly not sufficient--to allay inflationary fears. The fixed exchange rate regime will be sustainable only if the inflation rate compatible with public finance requirements is compatible with the inflation rate implied by the fixed exchange rate itself. This in turn is the cornerstone of the PECE. Thus, medium-term consistency requirements, when violated, signal great complications in short-term macroeconomic management, which will require restrictions on both the overall deficit and its mode of financing.  23. The debt package of 1989/90 reduced annual interest payments by about US$1.2 billion per year, or approximately 0.5 percent of GDP, through a combination of lower debt volume and lower interest rates. This alone yields a reduction in the equilibrium Inflation rate (i.e. the rate for which no further fiscal adjustment would be necessary) by S percentage points, from 25 to 20 percent based on 1989 fiscal policy parameters. This is a significant reduction, but by no means as dramatic as the impact of lower real interest rates on domestic debt. At an average real interest rate of 10 percent instead of 30 percent, the fiscal balance (which, at the 10 percent real rate that obtained for 1990 and inclusive of the effects of the debt package, will show an operational surplus of around 2 percent of GDP1 exerts no inflationary impulse at alls it can be financed wlthout any reliance on monetary financing. Thus, Mexico's dramatic fiscal adjustment is more than adequate for the inflation targets, if the credibility problems that underlay the extreme interest rates of the past can be overcome. The increase in inflation in 1990 cannot be ascribed to lack of fiscal austerity, but instead to a loosening of price controls and to adjustment of public sector and controlled prices. There was thus a "catch-up" component to it. Some cautious optimism about future inflation is therefore justified, even under continuation of current policies. F. The Pacto/PECE and the Recline in inflation since 1987 24. The Pacto/PECE was very successful: inflation was more than halved (from 159 to 52 percent) in 1988, and more than halved (to around 20 percent) again in 1989. Some rebound occurred in 1990; inflation rose to 30 percent. But the program clearly has been a success in having prevented a major recession. In fact this period saw the beginnings of renewed economic growth for Mexico. 25. Pacto's early success demonstrates that a change of policy can be made more credible, and strategic delays in price adjustments offset, by using wage-price guidelines and a fixed exchange rate to signal the new policy stance and snap a country out of a high-inflation equilibrium. But such measures lose their effectiveness if sustained for too long since they eventually signal not attainment of a new, low-inflation equilibrium but rather the economy's failure to achieve it. 26. Since inception of the Pacto/PECE, controlled prices and the prices of goods provided by public firms have been lagging considerably behind non- controlled prices and the prices of goods from private firms (see Figure 3, where electricity prices are used as a proxy for controlled prices). The figure shows another pattern, one that is revealing about Pacto/PECE's real effect. Public prices, after lagging most of 1989, were adjuated in discrete steps in December 1989, May 1990, and November 1990 (for a period extending to end-1991). These adjustments clearly contributed to lower relative price distortions; at the same time they triggered sharp increases in recorded inflation, pushing inflation above the 1989 level in the process. By the same token, the failure to adjust earlier has reduced recorded Inflation below what it would have been under a more gradual adjustment process. What the erratic adjustment pattern does is artificially lower recorded inflation in one year, only to raise it in the next year parallel to the necessary catch-up adjustments. Price controls by now seem to have become a mechanism for temporarily postponing inflation.  27. Pacto extensions (the latest Figure 3 in November 1990 until December 1991) have in fact implemented reductions in price controlus currently only 25 Ratio of Eectrtctty price Index percent of private sector prices over CPI. remain under control, down from "s 4 effectively 100 percent in 1988. It it Moreover, remaining controlled and public sector prices have been t adjusted considerably. Thus, progress has been made toward removal of interference in private price-setting. wtb Another indicator of the successful ht stabilization and increased credibility of the exchange rate policy is the reduction in domestic interest rates. Annual nominal interest rates on public debt recently dropped to around 25 percent. These rates are market determined, indicating that the private sector estimates inflation will be considerably below last year's 30 percent rate. 0. Medium-Term Finance for Growth 28. Mexico's general program of economic reform is well designed, skillfully implemented, and now reaching a crucial phase as it tackles what is by far the most distorted sector in Mexico--agriculture (see Part TI). Prior to the Gulf crisis, the program offered a sound medium-term funding package, although somewhat tilted to funding for its later years. Because of the high cash outlays needed for the debt package and because of the time required to translate direct foreign investment applications into actual projects, the early years of the program were underfunded and the later ones overfunded. For this reason, Bank strategy envisaged substantial structural adjustment lending initially and a rapid phasing out after FY91. 29. As indicated, the recent increase in oil prices has had a substantial impact on the Mexican balance of payments. The windfall gains in 1990 do not translate into more leeway for Mexico, however: under the 1990 program agreed to with the IMF, additional oil revenues are matched, with a small margin, by tighter reserve targets. As for the 1991 outlook, if the average price of Mexican oil is indeed US$23 a barrel, as assumed in the projections presented in this report, the windfall gain in 1991 would be between US$2.5 billion and US$3.3 billion (based on the pre-crisis projection of US$17.1 a barrel for 1991). Again, as indicated, Mexico's CY91 financing gap is highly sensitive to assumptions about future oil prices--an average 1991 price of about US$24 a barrel will be required to close the financing gap for the year. The government's intention of fully using any windfall for debt reduction or reserve accumulation is likely to be reflected in the economic program about to be negotiated with the IMF under the existing EFF agreement. The Bank's lending program has been designed as a compromise. Adjustment lending is cut back substantially to reflect the improved balance of payments situation but is not fully eliminated. This is in recognition of remaining rigidities and vulnerability because of the volatility of the major sources of external funds.  - 9 - 30. By cutting back but not eliminating adjustment lending, Bank strategy recognizes both the short-run uncertainty about oil prices and the need to safeguard the economy from future declines in the terms of trade. Cutting back adjustment lending tends to reduce Bank exposure and increase its capacity to respond flexibly in the event terms of trade decline. But retaining some adjustment lending provides Mexico with predictable balance of payments support in the event that the price of oil is lower than currently projected. And in the event that current projections are realized, the government can further "crisis proof" its economy through a domestic debt retirement program tied to the oil windfall. This would enhance the government's capacity to respond adequately in the future should the terms of trade deteriorate once again. Domestic debt reduction will also reduce the most volatile public expenditure item--domestic interest payments. (The Bank's strategy for Mexico is discussed further in Part II). H. External Debt and Creditworthiness 31. With implementation of the commercial bank debt reduction package in 1990, Mexico reduced the principal on its external debt by US$6.5 billion through the issue of discount bonds. In addition, US$22.8 billion was swapped for instruments carrying a fixed rate of 6.25 percent. Combined principal and interest debt relief totaled US$12.9 billion. Finally, debt-equity swaps equivalent to US$2.7 billion were auctioned in 1990, carrying an average 52 percent discount. However, implementation of the swaps is expected to take place primarily in 1991. Despite commercial debt reduction, total gross external debt rose slightly in 1990 to US$97.6 billion. This increase was due mainly to additional multilateral and bilateral lending in support of the debt reduction operation. Note that the debt figure does not net out the US$7 billion in collateral assets acquired by Mexico as part of the debt package. In 1990 the Bank's share of Mexico's long-term debt and debt service increased to 11.9 percent and 13.3 percent, respectively, while Mexico's share in the Bank's total exposure rose to 11.3 percent. However, Mexico's total debt service burden, which captures both principal and interest reduction, decreased from 40 percent of exports of goods and non-factor services in 1989 to 32.5 percent in 1990. The ratio of total debt to GDP dropped from 47.6 percent to 43 percent during the same period. Thus, provided that the current domestic economic policies continue, and the external environment remains favorable for the execution of the policies, Mexico is considered creditworthy for Bank lending.  - 10 - PART II - THE SECTORAL CONTEXT A. introduction 32. For more than three decades, Mexican agriculture has been the target of extensive government intervention. Overvalued exchange rates supported by a battery of trade controls discriminated against all tradable, including agriculture, while industrial sector protection reduced the agricultural/nonagricultural terms of trade. Intervention through subsidized foodstuff imports and selective price controls further reduced farmers, incomes. Subsidies on credit, irrigation water, fertilizer, seeds, and other inputs counterbalanced in part the lower prices for farm products while parastatals expanded their roles in marketing, stor4ge, and processing. By 1985 Mexico had perhaps the most thoroughly regulated and state-controlled trade and marketing regime in Latin America. The agricultural sector came to depend primarily on the government for credit, technology, inputs, storage, and processing. Government intervention, intended to aid the rural poor, promote food self-sufficiency, and compensate for an inadequate marketing infrastructure, actually benefitted the relatively better off farmers and suppressed development of private markets, private storage, agroindustry, and informal rural finance. As a result of these policies agricuitural growth has been slow, the alleviation of poverty in rural areas limited, and private investment low. 33. The de la Madrid and Salinas administrations moved to reform many of the detrimental policies, mainly in the macroeconomic and trade policy areas, thereby sharply reducing the negative impact of indirect interventions on agricultural growth and productivity. Exchange rate policy and industrial trade policy have been reformed. For example, the coverage of non-tariff barriers for most non-agricultural products has ceased, the tariff structure has become simpler, more uniform, and less protective, and measures to encourage exports are in place. In addition, some agricultural policy reforms have been implemented: the government has restructured and reduced the size of the parastatal sector, closed the government agricultural insurance agency (ANAGSA), begun reform of the agricultural credit system, rationalized and decentralized the Ministry of Agriculture and Hydraulic Resources (SARH), reduced subsidies on prices for fertilizer, electricity and water, and reoriented public investment in agriculture toward rainfed areas and small- scale irrigation projects. AGSAL I supported some of these reforms and many actions taken went beyond the agreed conditionality (see paras. 45-48 and Annex 5). 34. Now with discrimination against agriculture reduced, important reforms in agricultural policy are still necessary to exploit the full potential of Mexican agriculture to earn foreign exchange, increase domestic food supplies, and reduce food import dependency. The policy reforms under the proposed AGSAL II will build on and go beyond actions taken up to this moment and aim ats (a) increasing the rate of growth of agriculture, raising productivity, and improving the efficiency of the agricultural sector through better-functioning output and input markets; and (b) alleviating the poverty of the most vulnerable population groups through targeted food programs. Actions include: (a) trade and price policy reforms that increase competition and reduce the government's role in the production, planning, marketing,  - 11 - storage, and processing of agricultural products and inputs, by reducing consumer and producer price controls, lifting import and export restrictions, and allowing more competition from the private sector; and (b) revision in the allocation of government expenditures in consumer programs by improving targeted food assistance and nutrition programs, and assuring that poor consumers are protected from the real income losses resulting from the consumer price effects of agricultural protection of food commodities. B. Policy Issues for Aaricultural Growth and Productivity 35. Mexican agriculture's main problems have been its low growth rate, inefficient use of resources, and stagnating productivity. The roots of these problems are the direct policy interventions (price, trade and regulatory environment) in output and input markets and the decline in -ublic investment expenditure. The latter has probably led to a reduction in the stock of physical capital and in the development and availability of new agricultural technology. 1. Price, Trade Policy and Market Reaulations a. Backaround and Actions Taken 36. The government has set or strongly influenced consumer and producer prices for major agricultural and agroindustrial commodities, using international prices only as a reference. The most important objectives of these interventions have been, first, to keep consumer food prices low and, second, to raise rural income and achieve food self-sufficiency. During the 1980s the result of these policies was disappointing. Per capita agricultural production declined, and efforts to maintain low food prices in the urban areas led to large and growing consumer price subsidies. At the same time, producer prices were depressed for some products. 37. Farmaate prices. Prices guaranteed to producers were set for various crops each planting season (maize, beans, rice, wheat, barley, sorghum, soybean, cotton seed, cartamo, sunflower, copra and sesame, plus coffee, tobacco, sugarcane, and cocoa) and at the same level throughout Mexico. This penalized production close to consumption centers and subsidized production farther away. For food crops, CONASUPO channeled the subsidies covering transportation, losses, and storage costs. Furthermore, prices were adjusted infrequently during the year, distorting production decisions and making private storage unprofitable. 38. Because international prices, representing the opportunity cost of domestic production, served only as a reference for domestic prices, the level of producer prices relative to international prices has varied over time and by crop. The ratio of domestic to international prices depends on the prevailing exchange rate, government priorities, and the government's ability to cover the differential between low consumer prices and high producer prices. Because it became more difficult, for fiscal reasons, to maintain high guarantee prices and low consumer prices, adjustments in the guarantee prices have been moderate, and nominal rates of protection (NRP) are now lower than their peak in 1980-1982. They are still high, however, for maize (around 70 percent), wheat (around 40 percent), barley (around 60 percent), and sugar (around 80 percent).  - 12 - 39. Agricultural commodities outside the guarantee price system also have been subject to varying degrees of government intervention. This intervention did not result in higher producer prices in general because consumer prices (such as sugar) were controlled to favor the urban population. Until the second half of 1989, government parastatals were actively involved in the processing and marketing of major agricultural exports such as cotton, tobacco, coffee, and cocoa. Bad management and inadequate price policies generated large deficits and distorted market incentives. By liberalizing the market for these commodities and dismantling the parastatals, the government has reduced their drain on fiscal resources. 40. Real producer prices of commodities under the guarantee price system have experienced a long downward trend. In 1985-87 as a result of the fiscal crisis, the government decided to reduce the consumer-producer price differential for grains and oilseeds. Government expenditures for general subsidies on grains and oilseeds declined sharply from 0.5 percent of GDP in 1985 to 0.24 percent of GDP and 0.005 percent of GDP in 1986 and 1987, respectively. Combined with the desire to keep urban food prices low, this caused real farmgate prices to fall. In December 1987, as part of the Pacto, the government pledged to support real guarantee prices at their 1987 level. This, with the pledge to keep consumer food prices low, resulted in new subsidies for the production and consumption of agricultural products, that reached 0.37 percent of GDP in 1988 and 0.74 percent of GDP in 1989. During 1990 the government adjusted consumer prices upward while keeping producer price increases moderate, thereby reducing general government expenditure for maintaining a difference between producer and consumer prices of food. 41. Agricultural and Aaroindustrial Trade Recime. As part of its industrial development strategy, Mexico resorted to various trade interventions that in the end favored industry and damaged agriculture. Since mid-1985, however, these policies haye changed significantly. Key reforms include more flexible management of the nominal exchange rate to promote the tradeable sector, abolition of reference prices for imports, removal of licensing for most imports and exports, and reduction in the level and range of tariffs. (Some summary quantitative indicators of liberalization are shown in Table 1 below.) 42. On the import side, the tariff structure has been simplified and made more uniform and less protective. Between June 1986 and February 1990, the average tariff fell from about 24 percent to 12.5 percent, and the dispersion among sectors declined by more than half, to about 6.2 percent. Furthermore, the coverage of non-tariff barriers has been sharply reduced, and, as a result, the fraction of tradable national production covered by QRs has declined from 47 percent in June 1986 to 20 percent in June 1990, as measured by 1986 production weights. For the non-mineral primary and agroindustrial sectors (sectors 1-4 and 11-23 of the Standard International Trade Classification (SITC)), import liberalization has not proceeded as fast; about 30 percent of its production remains under QRs. Import barriers have been sharply reduced for major agricultural inputs such as machinery and pesticides. Thus, these overall and sectoral trade policy reforms have reduced direct and indirect price discrimination against agriculture. 43. Allowing the private sector to import basic foods, previously a monopoly of CONASUPO also has progressed. However, some important agricultural commodities still require import licenses, and CONASUPO retains  - 13 - its monopoly on importing beans and powdered milk. A significant constraint on competition in some areas iu that only industrial users are permitted to import a particular commodity (for example, maize). The exclusion of trading firms from importing goods is detrimental because, combined with the loss of economies of scale in importing, their absence discriminates against small processors. Food imports by the private sector also are constrained because, under the PECE, some controlled consumer prices have remained significantly lower than CIF import prices. 44. For many products, export controls enforce the set price; beef and rice are two important examples. consistent with AGSAL I conditionality export controls for high-quality rice and cuts of beef were eliminated. Export restrictions on fruits and vegetables, which represent 25 percent of crop output, have also been lifted. Moreover, export restrictions have been removed for other agricultural products. Tabi1: TRADE LI8ERALIZATION, 1985-1990 Ju8 Dc M86 D156 Jun87 De8 jun88 Nov89 Jun90 "imot Liesing gI 92.2 47.1 46.9 39.8 35.8 25.4 23.2 20.3 19.9 Refren Pfies A/ 18.7 25.4 19.6 18.7 13.4 0.6 0.0 0.0 0.0 Tariff-Mauimum 100.0 100.0 45.0 45.0 40.0 20.0 20.0 20.0 20.0 -Aveage h/ 23.5 28.5 24.0 24.5 22.7 11.8 11.0 12.8 12.5 Export Control A/ n.a. n.a. n.a. n.a. n.a. 24.8 23.4 17.9 17.6 Real Effective 100.0 121.8 134.7 145.2 136.0 128.5 112.6 115.0 113.1 Exchane Rate gI a' Percentage coveage of production of tadable; 1986 weights. h/ Weighted by producdon of tradable; 1986 weights; excludes five percent surchurge. g Inwase in the index reprsents a depreciation of the peso in real terms. Soure: Ba of Mexco 45. Mexico has made substantial progress in improving agricultural policy to allocate resources in the sector more efficiently. (Further details are presented in Annex 5.) Parts of this reform have been supported by AGSAL I under which the government agreed to: (a) maintain during 1988 guarantee prices for agricultural crops in real terms at the base prices prevailing on March 1, 1988; (b) set guarantee prices for 10 of 12 products in the system (except for maize and beans) within a 90-125 percent range of international prices, or within another range based on the results of a study on the guarantee price system; (c) remove export controls on high-quality rice and beef; (d) eliminate export controls or QRs on fruits and vegetables, except for hygienic reasons; and (e) reduce QRs on imports of agricultural and agroindustrial products by 5 percent of total national production from the level of such production existing on November 30, 1986. 46. The first condition under AGSAL I was intended to protect producers from eroding prices. The second condition reauired the movement of 10 auarantee 2rices into the 90-125 percent range of international prices. The guarantee price system has been abolished for these 10 crocs (and retained only for maize and beans). A decision has been announced to confine CONASUPO's purchases of these crops to the quantities needed for the CONASUPO  - 14 - distribution system only. This move represents a major step toward market- determined prices. However, a system of orecios de concertaci6n was introduced to encourage producers and industrial consumers to agree on prices. For products like rice, sorghum, soybeans, copra, sunflower, sesame, cartamo, and cottonseed where import permits have been eliminated, these prices are close to international prices because import tariffs are equal to, or less than, 20 percent. 47. AGSAL I also required the removal of export controle on high- quality rice and beef, fruits, and vegetables, except for hygienic reasons. These conditions were fulfilled. Moreover, the government lifted export permits for beef and cattle on the hoof (not just high-quallty cuts) and decreed the gradual reduction and elimination by September 1, 1992, of the tariff on exports of male animals weighing up to 280 kgs. Further detail. of these reforms are provided in Annex 5. 48. As part of the agricultural reform process aimed at enhancing competition and improving resource allocation, the following actions have been taken in outout marXetst (a) the differential domestic prices of sugar according to users were eliminatedt (b) domestic prices of paddy rice, sorghum, soybean, green coffee and cocoa are allowed to be freely determined by the market; (c) prices of roasted coffee and soluble coffee are allowed to fluctuate following the international price for green coffee; (d) restrictive export practices for fruits and vegetables have been eliminated; (e) import permits for sugar were eliminated and protection to the industry is now granted through a variable levy system; and (f) import permits for sorghum, copra, oilseeds and oilseed oils lifted; (g) restrictions that prevented entry into the corn-tortilla industry were abolished. 49. *GSAL I started the dialogue between the Bank and the government on agricultural policy and food consumption policy. AGSAL I was aimed at promoting greater efficiency and higher productivity in the agricultural and agroindustrial sectors, and supported reforms in the areas of consumer food subsidies and their targeting, improvement of producer pricing policies, privatization of parastatals, agricultural and agroindustrial trade liberalization, streamlining and decentralizing of the Ministry of Agriculture and rationalization of public investment in agriculture. Some of the actions taken by the government were beyond the conditionality agreed under AGSAL I, in particular on price and trade policy, decentralization and streamlining of the Minlstry of Agriculture, and privatization and parastatal reform.  - 15 - 50. AGSAL II continues and deepens the support of policy reform in some of the above areas and opens new areas for reform by supporting: (a) a deepening and broadening of the process of price and trade policy reform for agricultural products and inputs started under AGSAL I; (b) the dismantlement of SARH's system of crop production targets (not covered under AGSAL I); (c) the continued rationalization of public agricultural expenditure; (d) the protection of the real income of poor families by improving the effectiveness of the targeted subsidies and expanding its coverage; (e) the implementation of a food, nutrition and health pilot project which will determine and test the most adequate institutional arrangements and staffing to implement an expanded program at the national level; and (f) the process and impact evaluation of the pilot project and of the most important food consumption programs now in operation. The far-reaching actions taken by the government in parastatal reform and privatization of agricultural institutions do not require further support through AGSAL II. Reforms of specific agricultural institutions are supported by the time slice for irrigation, an agricultural technology project and a rural iinancial sector operation under preparation. 51. Parastatals. An extensive parastatal system controlled agricultural marketing, storage, processing, food distribution, and production and distribution of agricultural inputs. Major agricultural sector parastatals were the Mexican Sugar Company (AZUCAR), charged until recently with the production and distribution of sugar; CONASUPO, which controlled markets for basic grains; INMECAPE, which controlled the coffee market, TA8AMEX, the tobacco market, CONADECA, the cocoa market, and ANDSA, which is a storage warehouse business. The government has divested itself of INMECAFE, CONADECA, TA8AMEX, has privatized ICONSA (Industrias CONASUPO), has begun the process for privatizing ANDSA, and has sold all government owned sugar mills. 52. For parastatal divestiture, the following conditions were agreed upon under AGSAL I: (a) closure or sale of six sugar mills owned by AZUCAR; (b) liquidation of CONASUPO's wheat-processing affiliate TRICONSA; (c) closing, or moving to poor neighborhoods, 500 DICCONSA retail food outlets; and (d) sale or closure of 15 parastatals in the agricultural sector. Government actions have gone beyond these conditions (further details in Annex 5). 53. To reduce waste in public sector expenditures through agricultural parastatals engaged in marketing and promote private sector storage and marketing during project preparation, the government took the following actions: (a) 17 parastatals from SARH (excluding sugar mills) were liquidated in 1989 and 1990; (b) the distribution monopoly and the acquisition right of purchase of sugar from mills were taken away from AZUCAR, S.A.; (c) the 50 percent tax precluding private sector transactions in sugar and cocoa was eliminated; (d) the 50 government-owned sugar mills were fully divested; (e) the parastatals for coffee (INMECAFE), tobacco (TABAMEX), and cocoa (CONADECA) have withdrawn from marketing those products;  - 16 - (f) all plants of Alimentos Balanceados Mexicanos (ALBAMEX) but one were sold and the liquidation of the company was authorized; (g) it was decided to restructure CONASUPO and its affiliates; most important actions taken are: (i) divestiture of ICONSA; (ii) initiation of ANDSA's divestiture process; (iii) Bodegas Rurales CONASUPO (5ORUCONSA's) storage facilities are opened for commercial use by the social and private sectors; (iv) all 569 urban supermarkets were closed and (v) improvement of coverage of marginal areas by DICCONSA's rural stores. S4. Input Prices and Reoulations. To counterbalance discrimination against agriculture because of low farm prices, the government resorted to compensatory subsidies on redit and inputs. Almost all agricultural inputs-- including fertilizer, fuel, water, credit and crop insurance--are or were subsidized. These subsidies have distorted resource use, have had detrimental effects on agricultural institutions, and have raised the fiscal deficit. Meanwhile, government intervention in the seeds, feedetuffs, machinery and pesticides markets, has resulted in high prices relative to international prices, low-quality products, and burdensome trade barriers that hinder competition. 55. The most important subsidies have been provided through low cost credit, crop insurance, electricity, fertilizer, and water. During 1989, annual government expenditures to finance these subsidies reached approximately US$2.5 billion, distributed as follows: (a) US$2000 million for transfers to the rural financial system; (b) US$350 million for subsidies on electricity tariffs for irrigation; (c) US$100 million for fertilizer subsidies: and (d) US$50 million to cover the operating and maintenance expenses of irrigation districts. The government has started major reform of rural financial institutions, which already has reduced these financial sector subsidies and which will be supported by the planned rural financial sector project. Issues of water pricing are being addressed within the planned irrigation time-slice project. Remaining fertilizer pricing issues are dealt with under the existing fertilizer sector adjustment loan. Compliance with the conditions of this loan has been on target, and fertilizer prices are now 80 percent of international prices. Electricity pricing is also being adjusted under ongoing Bank loans to the power sector. Regulations and reforms in the seeds sector are being analyzed in the agricultural technology project under preparation. Two important restrictions on the seedc market that are proposed to be addressed in AGSAL II ares (a) the monopoly by PRONASE (Productora Nacional de Semillas) of germplasm produced by INIFAP; and (b) the limits on private plant breeding. A law is required to eliminate these restrictions. 56. AQricultural Machinerv. Mechanization of agriculture in Mexico has been constrained by high prices and the generally poor quality of machinery, thus hindering productivity gains in the sector. High prices on agricultural machinery reflect a history of import restrictions that protected domestic tractor producers and encouraged them to build up production capacity faster than was warranted by agriculture sector development. Since September 1989, domestic producers of agricultural machinery can import new machinery by paying the corresponding import duty (10 percent on parts for the assembly industry, on other agricultural machinery, and on Implements, and 15 percent on tractors). This practice creates a virtual oligopoly for producing firms  - 17 - and precludes the entry of traders who might be more efficient. To eliminate such monopolistic practices, reduce costs, and promote competition, the government has eliminated import permits for new agricultural machinery and equipment. 57. Pesticides. Agrochemical inputs have been characterized by high prices and uneven quality, resulting in higher production costs, and lower agricultural productivity. The structure of the industry, combined with government control, creates barriers to entry and reduces competition as well, which tends to drive prices up. The government's regulation of the market by enforcing entry barriers--without imposing in-factory quality controls-- favors dominant firms and results in the production of chemicals of uncertain quality. Dominant firms are price leaders, and they set prices, on average, above international levels. Barriers to entry result from registration procedures, import and export license requirements, price controls, and protracted government response. Reaistration is required for every agent who wants to produce, import, or distribute a product. It is an expensive process that can be handled only in Mexico City, and the registration must be renewed every two years. Pesticide import and extort 2ermits from SECOFI, SARH, SEDUE, and SSA are required because of trade, phytosanitary, environmental, and health reasons and are handled in an inter-governmental committee (CICOPLAPEST). To facilitate processing of permit applications, the government has published a manual that explains the steps that need to be taken to import pesticides. Moreover, during the Salinas administration prices of pesticides have not been controlled. 58. Regulation of the pesticide market needs revision to eliminate entry barriers and to establish clear long-term policy guidelines for economic, health and environmental purposes. This would mean dealing with health and environmental issues on strictly epidemiological and environmental grounds. To address these issues it is necessary to make a study to assess procedures and regulations on pesticide use and manufacturing. Similarly, animal health and plant protection regulations and related bureaucratic processes contribute to restricting external trade and domestic competition. Animal and plant services (provided by SARH) warrant adjustment to the emerging environment of trade and market liberalization. To promote and facilitate the adjustment to this new environment it is necessary to assess procedures and regulations on: (a) plant protection; and (b) animal health systems. 59. To enhance competition and improve resource allocation in input markets, since appraisal the government has taken the following actions: (a) abolished import licenses for new agricultural machinery; (b) allowed tractor prices to be freely determined by the market; and (c) initiated the process of submitting to Congress a draft seed law that will eliminate restrictions that impede private sector competition with PRONASE, PRONASE's monopoly of germplasm produced by INIFAP, and limits on plant breeding by the private sector.  - 18 - b. Pronosed Actions 60. In terms of price, trade policy, and market regulation, the objective of AGSAL II is to supports (a) liberalization of producer prices for agricultural commodities and their industrial derivatives5 (b) further liberalization of import and export trade in agricultural commodit'es and their Industrial derivatives; (c) development of private sector storage and marketing; (d) competition between the private sector and agricultural parastatals; (e) reduction of input subsidies and elimination of regulations on feedstuffs, machinery, and pesticides; and (f) regulation of pesticides, animal health, and plant protection based strictly on quality control, health, epidemiology, and environmental protection. 61. When loan preparation started in October 1989, the following elements characterized the state control of production, marketing, processing, and international trade of agricultural products in Mexico: (a) Guarantee (suoRort) _roducer prices for 12 food products (grains and oilseeds), plus coffee, cocoa, sugarcane, and tobacco; (b) Consumer nrice controls on around 50 products (those listed in Attachment 1 of Annex 4) and price controls on agricultural machinery and equipment, and fertilizers; (c) guantitative restrictions (QRs) on most agricultural imports; (d) Quantitative restrictions on all exports except high-quality rice and certain cuts of beef; (e) Taxes on exports of livestock, swine for breeding, coffee, and cotton; (f) Taxes on internal transactions of suaar and cocoa which discouraged the participation of private traders in the marketing of such products; (g) A larae oarastatal anparatus that intervened in the marketing, processing, and international trade of grains, oilseeds, coffee, cocoa, sugarcane, tobacco, milk, fertilizer, seeds, and other agricultural inputs; and (h) Mandatory oroduction Planning for the main agricultural commodities. 62. At the conclusion of the AGSAL It program, most constraints on production, marketing, processing and trade will have been dismantled, and the situation for agricultural policy, price, trade, and regulatory institutions in Mexico will be as follows: (a) Guarantee sauanortV producer prices eliminated for all but two products: maize and beans; (b) Consumer price controls eliminated for about 30 agricultural and agro-industrial products, and agricultural machinery, and subetantially relaxed (flexibilized) for another 16 commodities;  - 19 - (c) ORe on imports eliminated for all products but maize, wheat, barley, fruits, processed coffee, tobacco, cigarettes, chicken, poultry, meat, dairy products, and eggsl (d) ORe on exports eliminated for all products except maize, sugar and beans; (e) Nominal tariff protection not to exceed 20 percent (except for maize, sugar, barley and wheat); (f' ExDort taxes abolished; (g) Mandatory Droduction Dlanning abolished; and (h) A substantially reduced streamlined oarastatal apparatus, intervening only in the maize and beans markets. 63. To reach the above stage during the duration of the project, the government will implement an action plan for price and trade policy reform, whereby major trade restrictions and price interventions would be removed. The action plan involves the following componentss (a) elimination of most QRs for imports and exports; (b) elimination of existing export taxes; (c) elimination of consumer and producer price controls for a set of products, and greater administered price flexibility for those products still under control; (d) a cap of 20 percent on import tariffs, except for maize, sugar, wheat and barley; (e) publication of a decree that regulates new cane payment arrangements and the institutional aspects of the sugar sector; (f) the implementation of an action plan derived from the study on the edible beans market; (g) a mechanism to allocate milk import quotas in a transparent, competitive and efficient basis; and (h) a study to define sugar policy, the results of which will be used to approve and announce a policy for the sugar sector. The specific actions to be implemented are listed in para. 66 and summarized in the attachment to Annex 4. 64. During negotiations, agreement was reached on terms of reference for: (a) a sugar study to define the sugar policy, including the recommendation of a timetable for achieving a target level of protection for sugar not to exceed 20 percent (para. 146 (a)); (b) a study to define the price and trade policy for edible beans (para 146 (b)); (c) a study to design a system which will eliminate CONASUPO's monopoly on imports of powdered milk and will allocate import permits in a transparent, competitive and efficient basis (para. 146 (c)); (d) a study on pesticides to diagnose current use, assess present legal and institutional framework and streamline procedures to: (i) promote competition between producers and distributors; (ii) establish guidelines on minimum standards to deal with health and environmental issues; and (iii) enforce quality control (para 146 (d)); and  - 20 - (e) a study on animal health and plant protection tos (i) assess the regulation, organization and procedures of the system of plant protection and animal health; and (ii) elaborate a proposal to modernize the system and streamline its procedures (para. 146 (e)). 65. To enhance competition and better resource allocation in output markets, the Bank and the government agreed at negotiations that vrior to effectiveness the government will issue a decree that modifies present cane payment arrangements, eliminate export permits for wheat, sorghum, feedstuffs, barley, soybean, copra, cartamo, cotton seed, tobacco, eggs, coffee, rice, sesame, sunflower, vegetable oil (oilseed oils), beef and cattle on the hoof, and eliminate export taxes for raw cotton, cotton fibre, and swine for breeding (para. 147). It was also agreed that prior to second tranche release, the following actions will have to be taken (para. 149(a)(i)a.)s (a) implement a system which will eliminate CONASUPO's monopoly on imports of powdered milk, and allocate import permits in a transparent, competitive and efficient basis; (b) eliminate all export permits for fluid milk, and powdered milk; (c) allow for prices of tobacco to be freely determined by the market; (d) not to have increased the nominal protection for wheat above its level existing iI May 1, 1991; (e) flexibilize prices for cookies, pasta, edible oils, cigarettes, eggs, beef and dairy products; (f) not to have increased the guarantee price of maize to a level over its equivalent real U.S. dollar value for the Autumn-Winter cycle of 1990/1991; (g) not to have increased the domestic price of sugar above its equivalent real U.S. dollar value in January 1, 1991; (h) not to have increased the nominal price of barley for the period June 1, 1991 to January 31, 1992 above the level of 680,000 pesos per ton, and have set the nominal price of barley for the period February 1, 1992 to January 31, 1993 at a level not to exceed 714,000 pesos per ton; (i) discuss with the Bank the results of the sugar study and based on such discussions approve a policy for the sugar sector; Mj) agree on an action plan that follows from the edible beans market study; and (k) eliminate import permits for green coffee not later than September 30, 1991. 66. To enhance competition and improve resource allocation in input markets, it was agreed during negotiations that prior to second tranche the government will: (a) eliminate restrictions that impede private sector  - 21 - competition to PRONASE, PRONASE's monopoly of germplasm produced by INIFAP and limits on plant breeding by the private sector (para. 149(a)(ii)a.) t (b) maintain policy of allowing prices of pesticides to be freely determined by the market (para. 149(a)(ii)b.); and (c) reach agreement on action plans to implement recommendations of the studies on animal health, plant protection, and quality control of pesticides. Rules and regulations would be based strictly on quality control, health, epidemiological, phytosanitary and environmental protection grounds (para. 149(a)(ii)c.). 67. GATT and Free Trade Agreement with U.S. and Canada. The actions supported by AGSAL II will advance very significantly agricultural policy reform. Nevertheless, excessive protection for maize, sugar, wheat and barley will not be eliminated fully over the time period of program implementation for the reasons explained below. 68. In view of the ongoing GATT negotiations, and the forthcoming negotiations on the free trade agreement with the U.S. and Canada, the Mexican Government stated that it was unable to make commitments on protection levels and policy instruments for maize, wheat and barley. All these are commodities which are or can be imported from the U.S.A. The Bank agreed that policy conditions under AGSAL II should not in any way undermine Mexico's position in negotiating the free trade agreement. At the same time, the Mexican Government does not view the current high protection level as permanent but intends to fully define the policy regime for these commodities in the FTA negotiations. Under AGSAL II the government would commit itself either not to increase protection levels or to reduce them as explained below. 69. Masie. The government has agreed at negotiations to limit increases in the guarantee price of maize so that its real dollar value would not increase for the crop cycle Autumn-Winter 90/91, Spring-Summer 91/91, Autumn-Winter 91/92 and Spring-Summer 92/92 (see paras. 65(f) and 149 (a)(i)a.) 70. Wheat. During 1991, international wheat prices dropped 30 percent and protection levels increased relative to the domestic producer price (precio concertado). The government has agreed at negotiations not to increase the nominal protection of wheat over its present level, using a five year moving average of international prices to calculate the coefficient of nominal protection. (See paras. 65(d) and 149(a)(i)a). 71. Barley. The price of "concertaciono of barley has been set at 680,000 pesos per ton for the Spring-Summer 1990/91 and Autumn-Winter 91/92 production cycles which implies a nominal protection of 60 percent. The government has agreed at negotiations that it will increase nominal price for the 92/93 crop cycle by at most 5 percent. Given projected international prices, domestic inflation and exchange rate movements, this would lead to a reduction in real peso price and in protection levels. (See paras. 65(h) and 149(a)(i)a.) 72. Suaar. The government has implemented far-reaching reforms in sugar cane pricing and payment arrangements which will greatly enhance the efficiency of cane and sugar production. A decree will be issued shortly to formalize these new arrangements. It has also privatized all 50 sugar mills. The sugar industry requires major investments for rehabilitation and modernization. The government, sugar cane growers and sugar mill owners  - 22 - agreed on a domestic price policy which would make rehabilitation and investment profitable. This policy fixes a conotant real dollar price for sugar for the 1991 and 1992 crop years. The price is maintained constant through a variable levy on sugar imports. At today's international prices, the level of protection io about 80 percent. Changes to this recently agreed policy might jeopardize other agreements reached to modify the heavily regulated environment of the sector. The Government committed itself not to further increase the domestic price of sugar above its equivalent real doliar value on January 1, 1991. (See paras. 65(g) and 149(a)(i)a.). 73. The Mexican government considers that the level of protection and the timetable to phase out such protection should be the result of a detailed analysis of the situation of the sugar sector. Therefore it could not at this time commit to a particular level or to a timetable to reach it. It was agreed that, in the policy letter, the government will state its intention of moving to a maximum level of protection of 20 percent within a reasonable time span, a level which is consistent with the country's general tariff policy. The government will carry out a study to define sugar policy under terms of reference agreed with the Bank at negotiations. Based on presently available information the Bank would consider a reasonable time period to reach the stated policy objective not to exceed five years. Prior to second tranche release, the results of the study will be discussed with the Bank and, based on that discussion, a policy for the sugar sector will be approved and announced (paras. 65(i) and 149(a)(i)a.). 2. SARH's Production Taraets 74. SARH's production targets have been for many years a cornerstone of Mexican agricultural policy. SARH expected that its specific production goals be achieved, including greater food self-sufficiency in basic grains such as maize, wheat, rice, and beans. Production targets determined at the national level are used by government agencies to "guide" resource allocation at the farm level. 75. National targets become the basis for the targets for each agricultural development district and for each centro de anoyo, which interacts directly with the farmers. Support measures such as subsidized credit, fertilizers, and farm machinery encourage farmers to produce the selected commodities. Allocation and delivery of water for those crops is agreed upon between producers and government authorities. Extension efforts at SARH, Banco Nacional de Cr6dito Rural (BANRURAL), and Fideicomisos Instituidos en Relaci6n con la Agricultura (FIRA) concentrate heavily on the target crops--not necessarily the most profitable ones for the country. The waste inherent in this system was not as clearly a constraint on production as long as irrigated land and other resources were expanding rapidly. Yet as resource growth declined, the constraints imposed by the system became more apparent. This system of centralized planning with large subsidies for agriculture has not achieved its objectives. The end result is that the country is dependent on imports for its food supply. 76. This centralized system also would hinder transmission of the effects of the price and trade policy reforms to be implemented under AGSAL II, which are intended to increase productivity and improve resource  - 23 - allocation at the farm level. To allow the full transmission of price and trade policy reforms to the agriculture sector, as condition of effectiveness the Government will present a study which identifies processes, legislation and regulations that give SARH and other government entities the power to establish, coordinate and enforce crop production targets. Based on such study, the government will present to the Bank, not later than September 30, 1991, a satisfactory plan of action to eliminate and dismantle processes and regulations that enforce the system of crop production targets. (para. 147). This action plan will be implemented before second tranche (para. 149(b)(i)). 3. Government Expenditure 77. Total government expenditure in the agricultural sector was high, around 33 percent of agricultural GDP in 1988. This expenditure includes: (a) subsidies for credit, insurance, fertilizers, electriclty, and irrigatlon waterS (b) capital transfers to BANRURAL, ANAGSA, and other government entities and parastatalsg and (c) current and investment expenditure by SARH. Agriculture's poor performance in the 19800 Indicates that, overall, this expenditure has been unproductive and that substantial reforms are the only way to eliminate waste in government spending and increase the efficiency of future expenditures. a. Credit and Input Subsidies 78. Total input and credit subsidies in 1988 amounted to US$2.1 billion, four times the public investment budget in agriculture. Compreseing these subsidies has allowed to increase public agricultural investment while still sharply reducing expenditures. Untar-sted credit subsidies remain a major problem for agricultural policy and the government budget. The government, however, already has taken some action to restructure the rural financial subsector. It announced in February 1990 that ANAGSA would be liquidatedl since then ANAGSA has ceased to operate. The government has sharply cut staff and begun important institutional reforms of BANRURAL and is gradually transferring the cost of FIRA's technical assistance and guarantee fund to the producers. These actions are expected to result in lesser reliance on government funds in the medium term. The Rural Financial Sector Loan under preparation is addressing these and other related issues. 79. Fertilizer prices, which at present are 20 percent below international prices on average, are being increased according to the timetable agreed to under the Fertilizer sector Adjustment Loan. LoS electricity tariffs charged to farmers for operating irrigation pumps are also a major subsidy for agricultural production. The Federal Electricity Commission (Comisi6n Federal de Electricidad (CFE)) estimated that in 1988 electricity for irrigation and for corn mill. was sold at a ratio of price to long-run-marginal-cost of 0.26 and 0.21 respectively. However, between the first semester of 1989 and January 1991, real electricity tariff rates increased by 72 percent. Still, the ratio of price to long run marginal cost is below 0.40. A reform of electricity pricing is under way to reduce these subsidies.  - 24 - b. Investnt Expenditure 80. Public investment in the Mexican agricultural sector deteriorated sharply, falling in nominal terms from US$2.5 billion per year in 1980-82 to leos than US$0.7 billion in 1986-1988 (investment in agriculture as a percent of agricultural GDP fell from 18 percent to 6 percent during the period). As a result, rural infrastructure deteriorated. To improve rural infrastructure, under AGSAL I the government agreed to submit to congress an agriculture budget for 1989 that exceeded the 1988 budget (US$S503 million) by the equivalent of US$200 million in real terms. This condition was not fulfilled in 1989. Measured against actual expenditure, the increase in the investment budget between 1989 and 1988 was approximately US$80 million. However, the agriculture investment budget approved by Congress for 1990 was US$864 million, which represents a US$361 million increase over investment expenditures in 1988, thus exceeding substantially the objective of AGSAL I one year later. Although this recovery is important, major recovery of investment expenditure is still necessary to accelerate agricultural growth. 81. Investment expenditures in two areas need to be reviewed, for infrastructure and research and extension. Investment in rural roads, dams, and canal irrigation programs and the draining of floodplains and other major waterlogged areas have been a major source of agricultural growth in Mexico, and their expansion remains critical for future growth. The Mexican government has begun to redress the imbalance in agricultural investment by boosting investment expenditure to US$864 million in 1990 and US$1,112 million in 1991. 82. Technology development and extension also have suffered under fiscal retrenchment, particularly in the generation and distribution of agricultural technology. Principal issues are the inadequacy of financing public agricultural research, the means for transferring technology to agricultural producers, the definition of research priorities, and the legal and institutional aspects of seed production. In addition, definitions are also tequired for the appropriate division of labor between private and public research and for seed production. The proposed Agricultural Technology loan is expected to address these issues. An increase in public spending for research and development is needed to increase productivity and reach farmers effectively. 83. The government has provided satisfactory evidence that the level and composition of budgeted agricultural expenditures presented to Congress in the 1991 budget are consistent with the macroeconomic program and with an efficient allocation of Government resources at the sector level. Agreement was reached at negotiations that prior to second tranche release, the Mexican Government will provide satisfactory evidence that the level and composition of budgeted agricultural expenditure presented to congress in the 1992 budget is consistent with the macroeconomic program and with an efficient allocation of government resources at the sector level (para. 149(c)(i)). C. Food Congumotion and Nutrition 1. Introduction 84. Nexican food policy has long been concerned with balancing the need to keep producer prices high to stimulate domestic production and the  - 25 - need to keep consumer prices low to protect real consumer income, particularly for the poor. As a result, food consumption policy has not permitted the formulation and implementation of an independent agricultural price and trade policy and has led to large fiscal outlays that have not been cost effective in fighting poverty and malnutrition. The purpose of the food and nutrition component of AGSAL II is to makes (a) agricultural policy fully independent of food consumption policy; and (b) poverty alleviation programs more cost effective and successful by increasing coverage and improving targeting of the poorer population. 85. During the past two decades Mexico has not suffered any food shortages. Internal production has provided over 80 percent of the total food supply, the cost of food imports has been less than 10 percent of the value of total exports of goods and services, and the country has the infrastructure to store and transport food as needed. 86. Nevertheless, poverty and malnutrition, particularly among poor women and children, are widespread. According to nutrition surveys (Encuesta Nacional de Nutrici6n) in 1988, malnutrition among children under five years old is extensive, with estimates ranging from 22.3 percent (1.1 million children) when malnutrition is measured as low height for age (minus 2 standard deviations below average) to 13.9 percent (700,000 children) when it is measured as low weight for age (minus 2 standard deviations below average. Moreover, the national nutrition survey indicates that around 29 percent of non-pregnant women aged 12-49 have low weight for their height. Studies by Programa Nacional de Solidaridad (PRONASOL) indicate that in 1988 approximately 41 million people lived under poverty corditions, around 65 percent of them in rural areas. It is clear that low income, seasonal variations of food supplies, short-term unemployment, intra-family differences in food consumption, and nutrient losses due to parasites and other diseases are among the primary contributors to this situation. 87. While economic adjustment is the basis for more equitable growth, a coherent food consumption and nutrition strategy is needed now. Since the initiation of the Pacto, food price policy has been subordinated to the objectives of maintaining constant real wages and reducing the rate of inflation. This has led to rising costs in programs which drove a wedge between producer and consumer prices, reaching about 0.74 percent of GDP in 1989. Taraeted food 2roorams are directed mainly to urban groups and concentrated in the Federal District. It is estimated that the cost of these programs in 1989 was 0.13 percent of GDP. Nevertheless, 1990 saw a significant reduction of generalized subsidies and an increase of targeted subsidies. As a result, general subsidies declined to 0.49 percent of GDP in 1990 while targeted subsidies increased to 0.27 percent of GDP. Food assistance provided through the health system remains minimal. 88. Past consumer price policies undermined the considerable efforts to rationalize agricultural producer price and trade policies. Moreover, the current system, which does not rely anymore on general consumer subsidies to protect the real income of low-income urban groups, does not effectively address food consumption and nutritional objectives. This is because:  - 26 - (a) the rural poor receive only minimal benefits from the programs despite the high concentration of poverty and malnutrition in rural areas; (b) targeted food consumption programs do not take advantage of the proven complementarity among primary health services, nutrition, and nutrition education; (c) the programs are fragmented and use different targeting criteria and mechanisms; and (d) the current programs continue to force the government to handle large amounts of food and to maintain producer price and trade interventions. 2. A New Food Consumptign and Nutrition Stratea 89. Because Mexico's food and nutrition programs have been costly, fail to protect much of the population from malnutrition, and have a negative impact on agricultural producer incentives, a new strategy should: (a) sharply reduce under-nutrition and malnutrition in Mexico, especially in rural areas, at an acceptable fiscal coat; and (b) liberate agriculture policy and trade policy from their subordination to consumer price policy. 90. To prevent and correct malnutrition cost-effectively, it is necessary tos (a) reform the food and nutrition programs further; and (b) expand coverage of the target population substantially, especially in rural areas. This must be preceded by policy definitions and actions that support long-term policy objectives. a. Elements Already in Place 91. Current programs contain many elements worth preserving. During the 1980. Mexico introduced and expanded urban food subsidy programs (e.g. LICONSA milk coupons and Tortibonos see Annex 6). These have helped households, food security by supporting their purchasing power. The reformed Tortiboa2s program (Tortivales) which selects its beneficiary families from a recently completed list of all urban families with income below two minimum wages, entitles beneficiary families to receive tortilla coupons that can be exchanged for up to one kilogram of tortillas per day. The LICONSA milk program allows beneficiaries to purchase milk at subsidized prices (below production cost). Despite the lack of direct evidence and verification, it is reasonable to assume that these programs have prevented a major deterioration in the nutrition status of the urban population since the debt crisis. However, these programs cannot reach the rural poor who do not buy tortillas, and it is costly and cumbersome to distribute liquid milk in rural areas. 92. Since mid-1987 the maternal and child health care program has been delivering food baskets in 28 states to families with undernourished children under age five and to pregnant and nursing women. The program reaches only 140,000 families, however, while the total population eligible for coverage is estimated at 1.4 million. Integral Family Development (Desarrollo Integral de  - 27 - la Familia--DIF) implements other food and nutrition programs for selected families. 93. The main programs for protecting the purchasing power of the rural poor are: (a) the DICCONSA rural community stores; and (b) the maize flour program. The DICCONSA stores can deliver food to the most remote parts of Mexico and can serve a market-regulating function in areas with deficient retail systems. However, the DICCONSA stores effect a much smaller transfer of income to the rural population than do similar programs to the urban poor and cannot be used to enhance the purchasing power of the poorest rural groups substantially. The maize flour subsidy is a semi-targeted program that reaches only those rural poor who buy maize rather than grow it themselves. "Semi-targeting" is achieved through the choice of maize--the predominant food staple of the poor--as the commodity to be subsidized and by locating stores in poorer rural areas. 94. Following the findings and recommendations of a study of food and nutrition programs, on-going programs are being modified to improve their efficiency and targeting. Analytical work carried out by Comisi6n Nacional de Alimentaci6n (CONAL) has led to further classification of target populations and of each program's potential effectiveness. General food subsidies have been replaced by targeted ones. The Secretaria de Comercio and Fomento Industrial (SECOFI) and the Compafita Nacional de Subsistencias Populares (CONASUPO) are reforming their semi-targeted programs to improve their cost- effectiveness and income transfer effect. In addition, the Health Services Program for the Open (Uninsured) Population (Programa de Atencifn de Servicios de Salud para la Poblaci6n Abierta--PASSPA) model of primary health care will focus on improving and extending delivery of basic health care and nutrition assistance for 13 million uninsured people in Oaxaca, Chiapas, Hidalgo, Guerrero, and the Federal District. Special emphasis will be on families with undernourished pregnant and nursing women and children under five. The recently approved Primary Health Project supports the PASSPA program. 95. Finally, to improve the efficiency of various food and nutrition programs and to monitor their effects, Secretariat of Programming ard Budgeting (Secretaria de Programaci6n y Presupuesto--SPP), CONAL and the National Institute of Statistics, Geography and Information (INEGI) are developing proposals to enhance their ability to analyze and evaluate nutritional data. b. Kev Elements of the Long-Term Strateav 96. Although the current programs contain many positive elements, they are far from reaching their basic nutritional objectives. CONAL's report properly concludes that the prevalence of malnutrition--especially among women and pre-school children--demands direct actionY Experience shows that to 2/ CONAL - Documento Iintesiss Evaluaci6n de Proaramas para keiorar la Situaci6n Alimentaria v Nutricional de la Poblaci6n do Baios Inoreso-. Seounda Etapa (Evaluation of Programs to Improve the Food and Nutritional Situation of Low Income People.) (M6xico, D.F., Junio de 1989.)  - 28 - achieve food security and basic nutritional objectives in a cost-effective way, a strategy must require: (a) provision of food supplements to those at risk of malnutrition; (b) health interventions to prevent or treat parasitic and other diseases that generate waste of nutrients; (c) educating the population about better use of their available food; (d) providing the vulnerable population (pregnant women, lactating mothers and children under five) with sufficient purchasing power to obtain food; (e) using the haalth system to identify beneficiaries; (f) using the private sector to deliver food; and (g) eliminating untargeted subsidies and consumer price controls. 97. The most effective way to identify vulnerable groups is through schools and the health system, especially through nutrition-monitoring programs for pregnant and lactating women and for small children. Such monitoring programs are in place in the IMSS/PRONASOL and DIF (Integral Development of the Family) programs. Once identified, beneficiaries could use coupons at private and/or DICCONSA stores for food purchases. Combining food coupons with the provision of health services would greatly: (a) enhance targeting and, therefore, the effectiveness of the food programs; and (b) provide an impetus to improve the health service and thereby exploit the link between health and nutrition. 98. Based on these considerations, to achieve food security and adequate nutritional status for the poor and vulnerable groups of the population, the government has defined the following elements for its food consumption and nutrition strategy: (a) targeted food, nutrition and health programs, which are an important means to alleviate poverty and malnutrition in urban and rural areas; (b) program beneficiaries to be the poor (families with income below two minimum wages) and vulnerable groups. They will be the priority groups for an expanded nutrition and health program, with special emphasis on rural areas; (c) execution and expansion of food and nutrition programs based on an equitable distribution of benefits between urban and rural areas, acceptable fiscal cost, and allocation of resources among programs based on the results of a new monitoring and evaluation program; (d) the health system to play a central role, including the identification of beneficiaries (who will automatically become eligible for other food and nutrition programs); (e) means testing to be confined to urban areas; (f) CONASUPO and DICCONSA to handle food delivery to beneficiaries for the time being; (g) a pilot project, to evaluate procedures, operational viability, and cost-effectiveness of the nutrition and health program (see Section d); and  - 29 - (h) a monitoring and evaluation program for the pilot project and existing programs; results will be used to adjust the food and nutrition programs. 99. The Government of Mexico has prepared central guidelines for a medium-term food and nutrition program that incorporates the above elements of the strategy and has designated SPP as the agency in charge of coordinatings (a) budget allocation to the executing agencies; and (b) monitoring, evaluation, and research of the program. These guidelines have been incorporated into the food consumption component of the policy letter (see Annex 3). c. Cgonstraints and Transition 100. Three main factors constrain this strategy: (a) inadequate capacity of the basic health system to provide services in the urban and rural sectors alike; (b) inadequate budget for the existing primary health system, and expanding it to poverty areas; and (c) absence of government budget allocation for providing food through the nutrition and health program. All the other elements necessary to establish an effective food and nutrition program are there, especially the food distribution system of CONASUPO, DICOONSA, and private stores. 101. Since the health system is not able to cover a larger segment of the vulnerable population in the short- and medium-term, there is a rationale for maintaining the current targeted and semi-targeted food subsidy programs. The Tortivalos program is closer to a direct income transfer, and the LICONSA program, by focusing on mothers and children, is closer to a nutrition intervention-cum-income transfer. In the long run the Tortivales program can be: (a) maintained as an income transfer program for the urban poor by further improving its targeting and operation; or (b) merged with the nutrition and health program. Furthermore, because the LICONSA social milk supply program shares many elements with the proposed health and nutrition program, the infrastructure of the LICONSA program can be used to support the nutrition and health programs and be merged quickly with it. 102. The DICCONSA store system primarily regulates the market and provides only minimal targeted income transfer and nutrition benefits to the poorest of the rural poor. It also has the maize flour program, which consists of sales of maize flower below cost. As the coverage of the food and nutrition program increases, this subsidy will become redundant. In the short term, however, the maize flour program should be maintained in rural areas, as it is the only program capable of conferring substantial benefits to the rural poor at this time. d. kilot Nutrition and Health Proiect 103. The pilot project follows the basic design of the nutrition and health programs now under implementation by Secretaria de Salud. The pilot project will: (a) provide food assistance to around 45,000 rural families in the states of Nuevo Le6n, Tamaulipas, San Luis Potosi, and Mexico; and (b) test different methods for operating a nutrition and health program. Evaluation of the pilot project will provide adequate information on which to base an expanded national nutrition and health program. The localities which  - 30 - will be beneficiaries of the program were selected for two reasons. First, their extreme poverty, adverse climatic conditions, poor natural resource endowment, poor health infrastucture at the household level -absence of potable water and excretal disposal-, and high degree of malnutrition among children under 5 years made them a natural selection for this program. Second, because the selected towns are located in non-PASSPA states they do not have access to the benefits of PASSPA. Thus, for equity reasons, the pilot project will extend the benefits of poverty alleviation programs to those localities not covered by existing programs. 104. The main purpose of the pilot project is to guide the institutional arrangements and define the most adequate design for an expanded nutrition and health program. Its taraet -ooulation will be the low-income families at risk of malnutrition and for that include pregnant and lactating mothers or children under age five (estimated at 3.6 million families). The pilot program will cover 45,000 families and will: (a) be based on nutrition and health interventions to reduce maternal and child mortality, prevent and treat malnutrition, and promote a better growth and development of the target population; (b) determine and test the most adequate institutional arrangements and staffing to implement the nutrition and health program; (c) determine and test the most adequate packages of benefits and the criteria for selecting beneficiaries, with cost effectiveness of the proposed food supplementation basket(s) carefully evaluated, in particular; (d) determine and test the most adequate systems and procedures for (i) selecting and identifying beneficiaries; (ii) providing entitlements to food baskets; (iii) redeeming entitlements; and (iv) transporting and storing food baskets; (e) determine and test the design of the proposed information, supervision, accounting, and auditing systems and how to identify and assess the performance of the responsible units; (f) design and implement an action research program that will evaluate the effectiveness of the various nutrition and income-support interventions; (g) analyze the technical, administrative, and financial feasibility of the project activities, their estimated cost and timetables; and (h) prepare a detailed estimate of the cost of an expanded program for participating institutions, including unit costs, and costing criteria. e. Maize Consumotion Policy 105. Until recently, the government-owned ONASUPO subsidized maize and maize flour to urban tortilla manufacturers much that their prices were below both the international and the domestic price equivalents, therefore granting  - 31 - urban consumers untargeted maize subsidies. Rural consumers, about half of whom are net buyers of maize, were not receiving such subsidies, but paid essentially the producer price. During the past three years, producers were increasingly protected, leading to rising budgetary costs of maintaining low urban tortilla prices, and to rural consumers paying prices higher than the international equivalent. Ever since AGSAL I approval in 1988, it has been the objective of Mexican policy to reduce the untargeted subsidies to urban consumers, and to replace them with targeted distribution of maize to poor consumers. In the urban areas this has led to the Tortivales program which provides one kg of tortillas each per day free of charge to 2.1 million poor families. In the rural areas the government subsidizes maize flower and maize through its rural DICCONSA stores, which target the poorest areas. 106. The government recently proceeded to deregulate the maize-tortilla chain, simplify the complex structure of prices and subsidies stretching from the production of maize to the consumption of tortilla, and to reduce the budgetary cost of its maize policy. It therefore raised consumer prices of maize and tortillas to nearly the costs of CONASUPO of acquiring, handling and processing maize, thus raising consumer prices above their international equivalent. Only in Mexico City is the price of tortillas slightly below the international equivalent. The new price policy therefore amounts to a regressive consumer tax which falls mainly onto rural consumers and urban consumers outside of Mexico City, and which benefits producers. 107. Without maintaining the large and inefficient CONASUPO purchase and sales apparatus for maize, the consumer tax can only be eliminated by reforming producer price policy, a task which now has to be addressed in the context of the PTA negotiations. Pending the outcome of the PTA negotiations, to minimize the impact of the consumer tax on poor urban consumers, it was agreed at negotiations that the government will compensate poor families (those with income below two minimum wages) from the real income losses resulting from the consumer price effects of protection granted to agricultural producers in whatever food commodities the protection is applied. The instrument for this compensation will be the tortivale program or a suitably redesigned targeted food subsidy program. 108. For the rural areas the ultimate objective is to expand the pilot health and nutrition project to the national level. In the meantime it makes little sense to greatly increase or further target the existing maize and maize flower subsidy program through the DICCONSA stores, but rather just maintain it in its present form as a temporary and imperfect palliative measure. Therefore, in rural areas, DICCONSA will use its maize and maize flour programs in order to alleviate the impact on rural consumers of producer protection. However, as the nutrition and health program is expanded, the maize and maize flour programs can be phased out in those areas covered by the nutrition and health programs. 109. During neaotiations, the Bank and the Mexican government reached agreement on: (a) central guidelines for a medium-term food and nutrition program (para. 146(f)); (b) terms of reference for the design of a system to evaluate and monitor food and nutrition programs (para. 146(g));  - 32 - (c) a plan to implement the said monitoring and evaluation system (para. 146(h))t and (d) a process for using the results of the implemented ongoing monitoring and evaluation system (MES) to adjust the guidelines and programs according to the lessons learned from experience (para. 146(i)). 110. The government ham begun implementation of the food, nutrition and health pilot project. Evaluation of the experience derived from the pilot project and agreement on actions to extend a suitably revised program to a large segment of the vulnerable population are necessary to extend the benefits of these programs. During negotiations it was agreed that prior to second tranche release, the government will: (a) present to the Bank an evaluation of food and nutrition programs as agreed to in the implementation plan of the NES (para. 149(d)(i)); and (b) agree with the Bank on general and agencies' action plans for 1993-1994 (para. 149(d)(ii)). PART II! - OVRNMNT AND MANU &TR_UEOIE8 A. aovernment Strateaw 111. After a protracted period of falling per capita income, Mexico has resumed economic growth. Successful debt restructuring arrangements were finalized with the assistance of the Bank in 1990. Having achieved these goals, the government's overriding objective in the remainder of its six-year term (which ends in 1994) is to sustain economic growth and deepen the country's modernization process. To achieve these objectives, the ongoing stabilization process has to be consolidated successfully, external capital has to be attracted to spur investments, and structural reforms must be kept on track. Furthermore, the government is fully aware of the long term structural problems that could, if left neglected, derail any medium-term success. It has therefore declared agricultural reform, structural poverty alleviation and the environment as top priorities. Government at the same time is implementing its plans for decentralization to increase the fiscal authority and re isibilities of the states and municipalities. 112. The government strategy is based on the recovery of crowth throuah private sector investments, which would be complemented by supporting public investment. To create a climate conducive to private sector activity, the government intends to continue its structural reform program, which would help rationalize the incentive structure and further reduce government intervention in the economy. The government is proceeding with the privatisation of the telephone company and has announced the privatization of the commercial banks. The opening of negotiations with the USA and Canada for a free trade agrement is expected to take place later in the year. Privatization of the commercial banks is likely to improve the efficiency of the financial system, help public finances, and has already induced an increased return of flight capital. Major new initiatives have also been launched to eliminate the remaining anti- agricultural bias in the incentive and trade regime.  - 33 - 113. Public sector investments complementing private sector activity would be allocated for infrastructur to increase efficiency and service levels (ln irrigation, power, and transport); for noverty alleviation to emphasize basic social sector programs (including health, nutrition, and education) and safety net arrangements for the truly needy; and for the envirognmnt (air pollution, deforestation) to improve the health and living conditions of the country's people and economic growth. 114. The sharp increases in the price of oil since the September oil shock have altered Mexico's balance of payments outlook, but there is substantial uncertainty regarding balance of payments prospects. The government has been extremely cautious in calculating the potential windfall benefits, and has for the time being decided to utilize any increased oil generated foreign exchange earnings to increase reserves and decrease debt. S. Bank Assistance Strateav 115. The Bank has greatly expanded its assistance program to Mexico over the last five years. In FY85 commitments for the year amounted to US$598 million, and gross disbursements were US$788 million. Since then, Bank annual commitments to Mexico have more than doubled, in support of the government's adjustment program and structural reforms, including support for debt reduction. In FY90, gross disbursements reached an all time peak of US$3.6 billion in FY90, and net transfers, a peak of US$2.5 billion. 116. The government's successful adoption of a comprehensive and balanced economic program and the conclusion of Mexico's Bank supported debt restructuring exercise In early 1990, had begun to shift Bank lending strategy, even before the oil price change, from an emphasis on quickly disbursing adjustment operations to investment loans directed at infrastructure institution building, the improvement of services in the social sectors and the targeting of assistance to the poor. 117. Ae noted in Part I, if a US$23 per barrel average price of oil is sustained in 1991, then there would be a "windfall gain' between US$2.5 and of US$3.3 billion for the year over what had been projected based on a pre-criesi average price of US$17.1 per barrel. However, the projections for the price of oil are highly uncertain and Mexico's foreign exchange earnings are very sensitive to changes in economic conditions in the United States. Some additional quickly disbursing adjustment lending for FY91 is necessary to provide Mexico with a predictable source of balance of payments support. This would be done through this US$400 million AGSAL II and the US$25 million adjustment component of the recently approved Export Sector Loan (see para. 123)--as well as through IDB cofinancing of US$450 million for the two loans. 118. Provided there is no major change in Mexico's current balance of payments prospects, the Bank strategy is to continue the shift from adjustment to investment lending. The main thrust of the Bank's assistance strategy would then be to finance investment for physical and social infrastructure that would support private sector led growth. This would be complemented by specific operations to assist the poor and protect the environment. The strategy of shifting emphasis from adjustment to investment project lending requires strengthening the project pipeline. The Bank and the government are working together to do this.  - 34 - 119. As a result of the Bank's increased level of lending in Mexico over the last several years, its exposure in Mexico rose to US$11.03 billion as of the end of FY90, which amounted to 11.33 percent of the Bank's total exposure. Mexico remains in need of substantial amounts of lending to support the needs of its public sector investment program; however, the phasing down of adjustment loans will contribute to a gradual decline in Bank exposure, even with a continuation of substantial amounts of investment lending. The Bank strategy also contemplates continuing with an extensive and well-focussed economic and sector work program which could provide a basis for proceeding with adjustment lending if conditions warranted it. 120. Bank lending will emphasize infrastructure and human resource development in support of the government's efforts to revitalize private sector led growth. Infrastructure investment in the 1980s was reduced as part of the stabilization programs. As a result of this and the increased demand for infrastructure associated with the resumption of economic growth, expanded infrastructure investment is required. To meet these needs, a major emphasis in the Bank's lending program will be to support infrastructure investment and government policies to (a) reduce excessive regulation and interference; (b) decentralize administration and financing of infrastructure to the local level; and (c) utilize private sector management skills and capital to expand infrastructure services. Human resource development has also not kept pace with growth. During the sharp economic downturn of the 1980s, the human resources sector, which includes education, health, and nutrition, has suffered more than other sectors, and is now hampering the recovery. The Bank's program of financial and technical assistance is designed to support the government's increased efforts to strengthen Mexico's human capital base. In particular, the Bank program envisages assistance to basic education and health care as well as in the area of vocational education and manpower training. C. 8ectoral Comnosition of Bank Lendine 121. As of December 31, 1990, Mexico had received 126 loans from the Bank, amounting to US$16.73 billion, net of cancellationg and terminations; of these, 85 loans, totalling US$13.45 billion, were fully disbursed and US$3.28 billion remained undisbursed. The Bank's exposure was US$11.03 billion on a cash basis. The sectoral composition and policy content of past lending, as well as the design of major new lending operations are discussed below for key areas of the Mexican economy in which the Bank has been active over the years. Agriculture 122. Because of the crucial importance of agriculture for the one-third of the country's population living in rural areas, some 23 percent of the Bank's past lending has supported agricultural development, and nine operations are currently under supervision. The Bank's lending program in agriculture is aimed at: (a) helping correct the incentive regime in agriculture through gradual reductions in input subsidies and export controls; (b) promoting more efficient and rationale use of natural resources supported by improved technologies and services; (c) generating employment-intensive investments in rural areas and effective assistance to small farmers; and (d) creating an integral framework for sound rural development. To support  - 35 - these goals: in FY88 the Bank made a US$300 million AGSALI in FY90 made two loans (one for investments for agricultural marketing and storage facilities and the other for forestry development); and in FY91 made one for decentralization and regional development. Additional operations are planned to support rehabilitation of the irrigation infrastructure, including improved cost recovery and maintenance operations, for food security and poverty alleviation, and for agricultural technology. rade 123. About 10 percent of past Bank lending has been for trade, and two loans remain under supervision. Two trade policy loans (TPL I and TPL It) of US$500 million each were made in FY87 and FY88 in support of the government's sweeping trade reforms. The two operations supported the speedy reduction of non-tariff barriers (quotas and official reference prices) and rationalization of the tariff system (reduced levels and dispersion). The Bank supported the development of non-oil exports through two export development operations in FY83 and FY87. These export development loans were intended to strengthen the supply response by Mexican industry to the new trade policy signals. A US$500 million Industrial Sector Policy Loan (ISPL) in FY89 has supported additional trade measures designed to liberalize imports and rationalize the incentive regime in key subsectors. The recently approved US$300 million Export Sector Loan (ESL) will support trade and custom reforms and the transition of Bancomext to a more efficient role in trade financing in a more competitive financial system. Industry and Finance 124. Some 21 percent of the Bank's lending has supported industry, and currently eleven projects are under supervision. The Bank's lending strategy for industry, covering small- and medium-scale industry, mining, industrial restructuring and technology development, is designed to support: (a) trade policy reform; (b) strengthening a competitive financial sector, including the provision of resources for restructuring financial intermediaries; and (c) industrial restructuring, regulatory reform, clarification of foreign investment rules, and export promotion to assure a vigorous supply response to trade liberalization and increased international competitiveness. The FY89 US$500 million ISPL and the FY89 US$500 million Parastatal Enterprise Reform Loans provide support for policy reform in industry, and for the more efficient management and privatization of public enterprises. The PY88 Fertilizer and Steel Sector Loans and the FY89 Industrial Restructuring Loan provided support for restructuring of the fertilizer, steel, automotive parts, textile, and flower sectors, and other key private industrial subsectors in need of restructuring. Another adjustment operation in FY89, the USS500 million Financial Sector Adjustment Loan (FSAL), has been providing support for the liberalization of the financial sector, elimination of forced lending to the government at subsidized rates, increasing competition among banks and brokerage houses and improving regulations in the banking sector. Infrastructure 125. Lending for transportation, power and water accounts for 20 percent of the Bank's total in Mexico, with 8 projects currently under supervision. Lending for infrastructure is focussing on regional development, decentralization, more efficient public investment allocation, and improved  - 36 - cost recovery. Recent Bank loans supported the highway, railways and port sub-sectors. Emphasis was placed on obtaining more realistic user feel and deferring all but the highest-yielding investment projects so as to permit a minimum of budgetary outlays for maintenance expenditures and protect the existing capital stock. Proposed loans would support the government's decentralization initiatives, cost-based pricing, and managerial improvements. Loans are being considered to finance highway maintenance and construction, railway rehabilitation, port development, electric power energy development and water supply and sewerage system investment. Nousin@ and Others 126. The Bank has lent some 13 percent of its total for tourism, urban development, housing and vocational training. Currently three housing loans are under supervision. Government housing programs are designed to improve cost recovery. A Second Housing Finance Loan under execution is supporting graduated loan cost recovery linked to the income of final borrowers, thus ensuring a reduced drain on the budget. Further financing in the housing sector is contemplated which would benefit low-income groups and achieve further housing finance sector reform. D. Poverty, the Social Sectors and the Environment 127. While rapid, private sector-led growth is the most effective means of securing sustained increases in the incomes of the poor, not all will benefit from this process, or at least not quickly enough. This points to the need for special programs to assist the disadvantaged. The Bank's strategy is to support efforts to design more cost-effective programs for the provision of basic social services to the needy in the four poorest states of Mexico. Provision of low-cost housing and efforts to expand social safety nets to those outside the formal insurance programs are also in process. The Bank is assisting the government in redesigning public health, education, and human resource programs to make them more cost effective and targeted to meet the needs of the poor. A recently approved health project, the Bank's first in the sector in Mexico, would support decentralization measures, finance new primary health facilities, and strengthen professional services. similar initiatives are being pursued in education and nutrition. A basic education project is planned for next year and other operations are planned in the near future for vocational education and manpower training. A pilot project has been approved for improving the well-being of women in low-income areas. It includes the provision of piped water, health and educational services, training for productive activities, and credit for launching new microenterprises. 128. Bank strategy gives high priority to programs to safeguard the environment. The Bank is preparing an air pollution operation in the Federal District, which would tackle pollution caused by urban transport, and the Board has approved an amendment of an ongoing urban transport operation to support immediate relief measures requiring investments. A loan to support the Government's onvironmental ministry is under preparation. The loan would provide institutional assistance to the ministry, finance sectoral policy studies, prepare proposals for investment projects and help support mnnitoring and pollution control activities. To increase external resources, the Bank is promoting cofinancing of environmental investments, particularly with Japan.  - 37 - S. Collaboration with IFC 129. The IFC has worked with the Bank tot (a) identify private sector investment opportunities likely to thrive in the current climate of greater integration with the world economy; and (b) assist in strengthening the country's capital markets. In FY89 and FY90, IFC provided three lines of credit, totalling US$140 million, to commercial banks for industrial financing emphasizing export-oriented projects. As of March 31, 1991, the IFC had gros total commitments of US$1458.6 million in Mexico of which US$970.80 million had been sold, repaid or canceled. PALM IV - TU PROPOSD A. Rationale for AGSAL IL 130. Current Bank strategy recognizes both the short-run uncertainty over oil prices and the need to safeguard the Mexican economy from declines in the terms of trade. The macroeconomic justification for continued balance of payment support, albeit at substantially smaller levels than previously planned, also reflects the short-run volatility in the oil market and the long-run concern of insulating the economy from external shocks. With the macroeconomic situation calling for a reduced level of adjustment lending, current priorities in the Mexican adjustment program provide a clear rationale for focusing this reduced flow on the agricultural sector. 131. Continuation of agricultural policy reforms (price and trade policy) is key to further improving the incentives for the efficient and increased growth of the Mexican agricultural sector. Elimination of trade barriers is vital to permit the efficient transmission of signals that will guarantee that the full impact of reforms is felt. Reforms in food consumption policy are fundamental to: (a) improving the efficiency of government expenditure on anti-poverty programs; (b) increasing the living and nutritional standards of the poor; and (c) permitting a smooth shift away from a system of price and trade intervention. As government intervention declines and producers and consumers realize more freedom of choice, the need for a large parastatal sector disappears, and the closure of parastatals or their sale to the private sector will be a natural outcome of the reform process. 132. The government already has exceeded AGSAL I conditions in the price reform, trade reform, and reduction of agricultural parastatals. The strength of the ongoing programs and the impressive record of past actions in these areas provide the rationale for continued Bank support of the government's program of agricultural sector adjustment. 133. Other elements of the Bank's strategy for agriculture and rural development include: (a) the Decentralization and Regional Development Project that will support rural infrastructure in the four poorest states (FY91); (b) a planned irrigation sector time-slice loan that will support rehabilitation of existing irrigation systems, completion of unfinished projects, and initiation of a few high-payoff additions to the irrigation system (FY92); (c) a rural financial sector operation that will consolidate and deepen ongoing reform of the rural financial sector (FY92); and (d) the preparation of an agricultural technology operation to support the national research and extension effort (FY93). Agricultural environmental issues will  - 38 - be dealt with in each of these operations. For example, the agricultural technology operation is expected to contain a major component in support of soil conservation, research and extension, the irrigation sector loan will address salinity issues, and the AGSAL II will initiate reforms of pesticide policy. 134. In the area of food consumDtion and nutrition nolicX, AGSAL I supported the gradual shift from general to targeted food subsidies and sponsored an evaluation of food and nutrition policies and programs in Mexico. This evaluation led to selected but isolated reforms of food and nutrition programs and policies. The Bank has continued the dialogue with the government during the preparation of AGSAL II, aiming at the definition of a fully coherent food consumption and nutrition strategy that addresses the serious nutrition problems in the country, especially in rural areas. In this sontext, the government will carry out a pilot program to evaluate the feasibility and mechanisms of a health-based nutrition program that would combine health services and nutrition education with food entitlement. To expand at the national level, the health and nutrition program requires strengthening the basic health system, which the Bank is supporting through the recently approved Basic Health Care Project. 135. AGSAL II is a natural follow-up to AGSAL I, TPL I and II, and the Industrial Sector Policy Loan supporting trade liberalization, elimination of regulations, and price liberalization. AGSAL II also would have strong ties to the Fertilizer Sector Adjustment Loan, the ESL, and the Basic Health Care Project. B. Amount and Loan Obiectives 136. Loan Amount. The AGSAL II is proposed at US$400 million. The first tranche of US$200 million would become available upon loan effectiveness anticipated for July 1991, and the release of the second tranche of US$200 million is expected for August 1992 on fulfillment of: (a) specific conditions related to progress in implementing the program (see para. 149); and (b) general conditions referred to in para. 148. The closing date of AGSAL II would be February 28, 1993. 137. Obiectives. AGSAL II is part of a program of Bank support to the government's objectives of promoting efficient private sector development and increasing the effectiveness of public sector institutions so as to enable the resumption of economic growth. The loan would support: (a) trade and price policy reforms for expanding agricultural production; (b) food consumption policy reforms for reducing poverty, providing income protection to the poor, and improving the nutritional status of the most vulnerable groups of the population; and (c) the institutional transition of SARH to perform a smaller but more effective role in agriculture, emphasizing policy formulation and implementation and basic information and regulatory :unctions. C. The Borrower, the Guarantor. and Disbursements 138. Borrower and Guarantor. The government has designated Nacional Financiera S.N.C. (NAFIN) as the borrower, in line with its function as one of Mexico's official financial agents. NAPIN has also been the borrower under AGSAL I and its performance has been fully satisfactory. The loan would be guaranteed by the Mexican government. The Secretariat of Finance and Public  - 39 - Credit (SHCP) would be the project executing agent through SARH, SPP, SECOFI, and SSA. 139. Disbursements. The proposed US$400 million loan will support policy changes. Statements of expenditures (SOER) will be used as the basis for the preparation of the disbursement requests. These disbursements will be used to finance eligible import expenditures. Contracts in excess of US$5 million will be disbursed against full documentation. All adjustment loans to Mexico use a negative list because disbursements can only be made against Central Bank receipts, which cover only a fraction of Mexico's overall imports. Attempts to use a positive list in the past have been abandoned because of the small volume of imports against which disbursement could take place. D. Procurement and Financial Manacement and Auditina 140. Procurement. Contracts in the public and private sectors valued at US$5 million or more would be procured through international competitive bidding (ICB) with simplified advertising and currency provisions following World Bank guidelines. Procurement has been satisfactorily handled in previous adjustment loans. Therefore, contracts valued below the ICB threshold would continue to be awarded, as in past operations, on the basis of the normal procurement practices of the purchasers, which have been reviewed and are acceptable to the Bank. 141. Financial Manasement and Auditing. The borrower would be responsible for maintaining loan accounts and for preparing and submitting withdrawal applications. Withdrawals from the loan account would be on the basis of statements of expenditures (SORs), and Banco de Mexico would ensure that all supporting documentation is maintained adequately and made available for review by the Bank. Disbursements will be made for eligible imports, i.e., those not specifically excluded (the standard "negative list"). Audits of the accounts of the project and the supporting documentation for SONs will be carried out by independent auditors. The audit reports will be submitted to the Bank as follows: (a) for the first tranche, within a period of 120 days after the disbursement of the tranche; and (b) for the second tranche, within 120 days of the full disbursement. A timely and acceptable (clean auditors' opinion) audit report after first tranche release must be received prior to releasing the second tranche. S. Benefits and Risks 142. Benefits. Implementing price and trade reforms, dismantling system of mandatory production planning, streamlining regulations on plant protection, animal health and pesticides, and allocating government expenditures towards infrastructure and development of new technologies will improve incentives for efficient sector growth. Liberalizing prices and trade will allow producers and consumers to exploit the best production and trading opportunities in both domestic and international markets. Dismantling system of mandatory production planning will let production and marketing decisions be based on price signals and market opportunities rather than by bureaucratic processes. streamlining present regulations on plant protection, animal health and pesticides will result in, first, simpler and more efficient administration of regulatory system, second, elimination of artificial barriers to entry and competition, and third, adoption of rules and procedures  - 40 - which will facilitate Mexico's access to international markets. Targeting programs to the poor and vulnerable population, increasing their coverage and monitoring and evaluating food and nutrition programs will: (a) separate agricultural and food consumption policy; (b) provide transparency and distinguish budget allocations which support agricultural producers from those that protect the poor; and (c) make government expenditure in food and nutrition programs more cost effective. As a result, the government will be able to reduce the incidence of malnutrition by the end of the current administration. 143. Risks. Firgt, one important lesson of economic history is that the macroeconomic climate must be supportive of policy reforms. The key requirements are fiscal discipline, a prudent monetary policy, and a realistic exchange rate. Policy reversal in any of these areas would endanger the program. Second, the very purpose of agricultural policy reform is to encourage improved resource allocation. Changes In patterns of resource use often are resisted by those who benefit from the status quo. If governments do not resolutely follow through with credible policy change, the momentum for reform may be lost and the program endangered. Third, relying on the U.S.- Mexico-Canada PTA to implement trade policy reform in maize, wheat, and barley does not necessarily guarantee trade and price liberalization. Over the past five years the Mexican record of overall policy reform has been strong, sometimes going beyond Bank's conditionality. Moreover, the U.S. and Canada, large producers of wheat and maize, have strong interests in guaranteeing their producerb -ccess to the potentially large Mexican market. Therefore, the risks seem manageable and are outweighed by the likely benefits of AGSAL II. P. Coflnancina 144. The Bank and the IDB have collaborated closely in the preparation of AGSAL 1I, and IDS is planning to cofinance the program with a loan of US$200 million. G. Neaotiations. Effectiveness. Dated Covenants and Secoid Tranche Release Conditi2na 145. At negotiations, the government and the Bank agreed on the final text of the government's policy letter on acriculture and food consumption (policv letter) policy statement and on the timetable for the introduction of the policy reforms. The policy letter describes a program of actions, objectives and policies designed to promote greater efficiency and higher productivity in Mexican agricultural and agro-industrial sectors, reduce poverty and malnutrition and improve the cost-effectiveness of government expenditures in food and nutrition programs. This policy letter has two partst one on agricultural growth and productivity and other on food consumption and nutrition policy (see Annex 3). In the part on agricultural arowth and oroductivitv the governments (a) reaffirms the continuation of reforms and sets out a plan for further action on price and trade policy for agricultural commodities and inputs; (b) reaffirms its intention to dismantle barriers to entry and competition since they hamper resource allocation; (c) agrees to streamline those rules and regulations required for the efficient operation of markets; and (d) states its intention to allocate investment expenditure to improve rural infrastructure and agricultural research and extension. In the section on food consumption and nutrition the  - 41 - government states its intention oft (a) compensating poor families for the real income losses from the consumer price effects of protecting agricultural food production; (b) improving the present system of targeted subsidies; (c) implementing a pilot nutrition and health program; and (d) increasing the coverage of food consumption and nutrition programs in rural areas. The specific actions taken and to be taken are detailed in para. 149 and the policy matrix and its attachment (Annex 4). 146. During negotiations, the Bank and the Mexican government reached agreement on: (a) a sugar study to define the sugar policy, including the recommendation of a timetable for achieving a target level of protection for sugar not to exceed 20 percent (para. 64 (a)); (b) a study to define the price and trade policy for edible beans (para. 64(b)); (c) a study to design a system which will eliminate CONASUPOS'S monopoly on imports of powdered milk and will allocate import permits in a traisparent, competitive and efficient basis (para. 64(c)); (d) a study on peL.icides to diagnose current use, assess present legal and institutional framework and streamline procedures to: (i) promote competition between producers and distributors; (ii) establish guidelines on minimum standards to deal with health and environmental issues; and (iii) enforce quality control (para. 64(d)); (e) a study on animal health and plant protection to: (i) assess the regulation, organization and procedures of the system of plant protection and animal health; and (ii) elaborate a proposal to modernize the system and streamline its procedures (para. 64(e)); (f) central guidelines for a medium-term food and nutrition program (para. 109(a)); (g) terms of reference for the design of a system to evaluate and monitor food and nutrition programs (para. 109(b)); (h) plan to implement the said monitoring and evaluation system (para. 109(c)); and (i) a process for using the results of the implemented ongoing monitoring and evaluation system (MES) to adjust the guidelines and programs according to the lessons learned from experience (para. 109(d)). 147. Prior to geffctiveneas, the government has agreed to: (a) issue a decree that modifies present cane payment arrangements (para. 65); (b) eliminate export permits for wheat, sorghum, feedetuffs, barley, soybean, copra, cartamo, cotton seed, tobacco, eggs, coffee, rice, sesame, sunflower, vegetable oil (oilseed oils), beef and cattle on the hoof (para. 65); (c) eliminate export taxes for raw cotton, cotton fibre, and swine for breeding  - 42 - (para. 65); and (d) present to the Bank a study which identifies processes, legislation and regulations that give SARH and other government entities the power to establish, coordinate and enforce crop production targets (see para. 76). As dated covenants it was agreed that not later than September 30, 1991: (a) based on the study, the government will present a satisfactory action plan to eliminate and dismantle processes and regulations that enforce the system of crop production targets (para. 76); and (b) the government will eliminate import permits for green coffee (para. 65(k)). 148. General conditions for aecond tranche release are: (a) that the government will provide the Bank with evidence that the macroeconomic policy framework is consistent; and (b) maintaining the policy reforms implemented up to Board presentation and documented under this project. (Actions described in the policy matrix and its attachment; see Annex 4.) 149. During necotiations agreement was reached that the following actions, satisfactory to the Bank, will have to be taken prior to second tranche (see also Annex 4): (a) Price. Trade Policy and Market Reaulations (i) Output Markets a. Implement the action plan agreed upon and described in (para. 65(a) to 65(k)); and (ii) input Markets and Health Regulations a. Eliminate restrictions that impede private sector competition to PRONASE, PRONASE's monopoly of germplasm produced by INIFAP and limits on plant breeding by the private sector (para. 66(a)). b. maintain policy of allowing prices of pesticides to be freely determined by the markets (para. 66(b)); c. agree on action plans to implement recommendations of the studies on animal health, plant protection, and quality control of pesticides (para. 66(c)); and (b) SARH's Production Taraets (i) Implement actions agreed upon to eliminate and dismantle processes, legislation and regulations that enforce the system of crop production targets (para. 76). (c) Public ExDenditure (i) Provision of satisfactory evidence that the level and composition of budgeted agricultural expenditure presented to Congress in the 1992 budget is consistent with the macroeconomic program and with an efficient allocation of Government resources at the sector level (para. 83).  - 43 - (d) Food Consuamtion and Nutrition (i) Present evaluation of food and nutrition programs as agreed to in the implementation plan of the monitoring and evaluation system (MRS) (para. 110(a)); and (li) agree with the Bank on general and agencies' action plans for 1993-1994 (para. 110(b)). PkMT V - COLLABORATION WITS TINF 150. Bank/IMF collaboration has been close over the years, especially since 1982 when the Fund began to assist the government in addressing the underlying causes of its economic crisis. Since that time, the government has bonefitted from an extended arrangement for SDRS 3.4 billion, a special emergency drawing for 8DRo 291 million after the 1985 earthquake, a stand-by for SDRs 1.4 billion in 1986, and in 1989 for an SDRs 2.8 billion extended arrangement through 1992, and a drawing of SDRe 453 million under the compensatory facility. 151. Consultations between Fund and Bank staff concerning Mexico's current economic situation and prospects have led to a common understanding about the measures needed to bring the stabilization program to a successful conclusion, strengthen the balance of payments, and restore sustainable growth. Further consultations on macroeconomic performance will take place between the two institutions during our ongoing adjustment operations. PMRT VI - R3COMHNEDaXION 152. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank, and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Attachments May 29, 1991 Washington, D.C.  APa4 Ic am ......... . . . .7 7A & 0.1 0.6 L.0 4.2 .8 0.0 -00 .4.2 30 2.6 -.7 1.7 1.1 3.2 $A gPDnfie1a 9 .8 18* 28. 4.0 2.8 10.0 106 20.7 28 60.0 sos6 881 50.7 74A Ml8. *01.7 a". MA. hIafm 00 e fb . .-. 5, . . .2 158%81 as.,3s 2.0w SL.o* so..9% o1.s% 5.n% 80.2% 1,1.8% 114.2% 20.0% 20610 dopwcapu - LS~8. 31 8. .1 S 0&1 1.2 8A 8.1 -8.1 -76 0 -84. -1A .-.4 -0.0 0.0 1. Oansmagtmncp.rCla.......... 0.2 2.0 . -1 l.a IA 1.7 4 4.8 -1.4 0. 0.2 .. -7.7 -0.0 -2.2 1.0 0 FbdladuliIsWags at.._ &.1 4 -1.1 1.7 6O0 0.6 1I" -4A4 1.2 1.0 -R 2.0 1. -10.2 4* -12.7 .0.0 _.1 Totalwwmnm t-.............. 10.6 21.0 26.2 I6 20.6 21.3 20. 27.2 27. 22.8 20.0 1* 21.2 16.2 19.2 21.0 22.8 10.7 Milon Savig. .................17.8 18.8 21.3 13A4 17.6 17.8 10.7 21* 20. 20.6 2&* 22.2 27.0 17.2 21.0 1IO4 20.9 10.4 GOP fstrAcclnt ........-21 .41 &. -2.0 -2.0 -8&2 -&0 -8L8 -0.4 -&.0 3. 2.4 0.7 -1.3 28 -1.6 -1.* -2.2 Cwffst Accut .... .470 -2804 .448 .42 -408 -1218 .870 -10740 -1606 .92 6418 42U1 1267 -1078 am8 -am0 -mm8 -826 empmtol Goods &tNon FaL t. 1er10e 1064 S08 108w 1872 98e 288 7020 2004 280IP 2640 71S5 001S8 270 21678 27814 2006 89888 38388 Not kwwleMaIoa Rm vo (sop).. 01 1261 21ee 460 838 744 682 8163 4607 166 SW2 6600 22 2870 822 1202 206 OM t~cflsG8se1gicwtiia1....... 62 7*9 0.9 1* 8.8 -68. 10.0 6.1 11 21*8 1.6 6.7 4.A L* 10.7 &0 3.* 8.2 0O Exo or grcwlh. Mo__.. - 28. 40. .. . - . 71.0 20.8 31. 6.0 1.1 .0.0 -.4 -.3 3.2 -a 4.6 MNw-cl ESpo t. ral rwth rmte . . 008 2.s . .. . -1.8 0.2 -16.2 07* 28.8 -4.0 80. S". -12 2.5 10 E,cfl. OweF noodna pomwU tw.... 0. a1 27A 80; 10.7 0 12.7 66. MG* .9 8.9 109 4A4 -20.0 28.2 63 13.2 17.6 Eqw%rta0IU0wMenDP..--.----- 0.8 a 12.8 11.4 7*8 7.0 7.4 10.7 10.4 16.3 10, 17.2 18.0 1.8. 10.7 16.7 15,7 10.2 "A GO" me 8rafgrwthts.L.. . 0O4 0.6 20 8.8 10.1 I 31.0 17.8 -87.0 -88. 17. 11 -12.4 4.5 37.6 18.6 18.0 hcul tPncrudnalpcwth ae .... 0.6 10.8 21 15. 4.7 MA. 0.0* 68.2 30.2 -40.6 .481& 28 18. -11.7 8.7 44.7 91.3 27.1 P,Iip tGUMOIOurlwt OMP........... 11.4 0.6 12 139 as6 0.2 0.2 12.0 12.8 11.6 0.6 0. 10.0 12.6 12.3 14.3 14*e 10.7 R.bourc9ajemoefrarrnt GP.... .2.1 -1.8 0* .8 -1*8 .21 -1.0 2. -2.4 8.6 9.7 7.0 6.0 4*3 .4 2.4 0.6 .0.8 Twrm of TVWd hadex (1060-100).. 686 &68. 104. 68.7 08,1 60. 78.3 100 07.4 64.8 77.4 70.1 72 61tA 87.3 86.2 66.1 Rinalfulhwge Relebxex (1060100) bi 106* 106.2 111.8 118. 106. 104.0 106.3 100 90.7 134.8 137.8 114 *111.7 148. IOtA 2L4 117.3 112.5 Faeo. Debt h,Ddkatme l TOta DOO34Uon US$).-- 3514 I1I4 66126 . 2212 606 20610 8737 7021 6601 0M6 0402 0656 10007 1004.4? 10018 0681 1012212 Pub4*000 ..... .... 28 7546 8161M . 1487 8106 16806 3801 43033 15681 6676 675 72701 7800 04336 8066 MS?8 70I Plivats Mt.ngrwnntsd DOD_ 1*10 850 2868 764 277 4843.2 7300 10200 0100 14600 I6SM 15748 18108 14148 6081 3000 OM0 Tota DOoOdExceteNFO(% 146. VIA. 311* . 111.2 m2.0 292. 278,3 300.6 810. 342.2 814.7 360.6 461.1 006. 344.8 201. MA8. TOWDoia 0cuftem GOMP (9) 18 10.4 87 10.2 16L6 21.6 20.8 81*3 60.A S". 6.0 6a" 77.6 77*9 87.0 48.6 48. OMb ServIce ULT (Uonus ....9 66 1275 6128 . 468 1300 S34 O840 109 12800 1207 16907 14484 1200 11064 137M 12137 1028 0obtGso emMLTXWnw46tGP(4.. Li1 19 8.2 .. 2. 8.4 3.8 4. 4. 7.2 0.7 8.1 7*8 0* 7 7.0 6.8 4*3 Debt Sevlm ULTIExpor 6OM (10). 24 28 48 . 28.5 48,4 47.7 44. 40.8 47.0 47.0 62. 62. 6S" 40.1 47.3 38* W. h Oers!tMLT (MUn US$) 1SS 662 1069 .. 7 20 108 4660 611 776 81W 1026 00M 707 7601 7541 780 7172 biterest LTIExpcftQW8PS(10) ....8L 10.2 18.6 . 4.4 10.6 18.4 22.0 28.8 20.7 30.0 34.0 34. 86.1 27.0 26.0 8. 18.7 WOessMLTFCnRiAGO tBb(.... . . 085 0.0 2.4 .. 0A 0.7 1.4 2.4 2.4 4.0 68 6.8 1 6.0 8. 4.3 8. 8.0 Uomvuldm bm Prik y limos (t of OM ..... .. .. . 0.0 -1.4 -4.6 -8.0 -8.0 -.8 4.6 &S6 8.0 2.0 5.6 7*9 7.7 6.0 kA 4 EN WlONe(W*cI(0of OM.. .. -1.1 -8.6 -8.8 -4.6 -10.6 -11.2 -.1 -4.1 -4*6 -8.0 1.1 -4 -2.2 mE/GO .........2.7 20.1 27.0 10.8 21.8 so.7 28.6 1*3 38. 87.2 34.1 0S* OM. 41*0 48.7 08.0 381 Mcnet.y a-(a muhal) .... ... 14.0 1*9 86.1 1 12.2 10.7 20.8 41.2 48.1 0.4 68.1 64.1 17.6 47.7 70*3 42.3 10.6 d UGIiibig In 1867 me redl lnkht,le minbuan- mg es biAs -memta h- bysSes ugoeA I pimfdemo. Iare IRm. Fa dePreltlOon di Refers a to06-76  - J45 - | J P , * 3~ 2g~qn h mqqq*I-g s flq 22