Mexico - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 16056-ME MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE UNITED MEXICAN STATES OCTOBER 15, 1996 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENT Currency Unit Mexico New Peso (MexN$) US$1.0( = MexN$7.615 (October 10, 1996) ABBREVIATIONS AND ACRONYMS ABS Asset Backed Securities AFORES Administradoras de Fondos para el Retiro (Pension Fund Administrators) ARCS Audit Reports Compliance System ABS Asset Backed Securities BIS Bank for International Settlements CEM Country Economic Memorandum CFE Comision Federal de Electricidad (Federal Electricity Commission) C'IMO Programa de Calidad Integral y Modernizaci6n (Productivity Enhancement Program) CNBV Comisi6n Nacional Bancaria (National Banking Commission) EDI Economic Development Institute EFF Extended Fund Facility ESW Economic and Sector Work FIAS Foreign Investment Advisory Service FIRA Fideicomisos Instituidos en Relaci6n con la Agricultura (Trust Fund for Agriculture) FOBAPROA Fondo Bancario de Protecci6n al Ahorro (Bank Fund for Savings Protection) FOVI Fondo De Opcraci6n Y Financiamiento Bancario a la Vivienda (Bank Housing Finance Fund) F()'VISSSTE Fondo para la Vivienda de los Trabajadores del ISSSTE (Government Workers' Housing Fund) FSRL Financial Sector ResiLicturing Loan F-TAL Financial Technical Assistance Loan GAB General Arrangemenits to Borrow GAAP Gencrally Accepted Accounting Principles IDB Inter-Americani Development Bank IDF Institutional Development Fund INFONAVIT Instituto del Fondo Nacional de la Vivienda de los Trabajadores (National Workers' Housing Fund Institute) MBS Mortgage Backed Securities NAFIN Nacional Financiera, S.N.C. NAFTA North American Free Trade Agreement NGO Non-Governmental Organization O&M Operations and Maintenance PARE Programa para Abatir el Rezago Educativo (Bank's first Primary Education Project) PEMEX Petr6leos Mexicanos PESE Programa Especial de Empleo (Special Employment Program) PROBECAT Programa de Becas de Capacitaci6n para Trabajadores (Labor Retraining Program) PROCEDE Programa de Certificaci6n de Derechos Ejidales v Titilaci6n de Solares Urbanos (Program for Certification of Ejido Rights) PROCAMPO Programa de Apoyos Directos al Campo (Farm Support Payments Program) PRODUCE Agricultural Services Program PROFORESTAL Forestry Program PRONASOL Programa Nacional de Solidaridad (National Solidarity Program) PROSSE Programa de Servicios Sociales Esenciales (Program of Essential Social Services) PTAL Privatization Technical Assistance Loan SAGAR Secretaria de Agricultura Ganadera y Desarrollo Rural (Ministry of Agriculture and Rural Development) SAR Sistema de Ahorro para el Retiro (Retirement Saving System) SME Small and Medium Enterprises SOFOL Sociedad Financiera de Objeto Limitado (Limited Purpose Bank) SSI Southern States Initiative UCABE Unidad Coordinadora para el Acuerdo Bancario Empresarial (Bank Enterprise Workout Coordinating Unit)  FOR OFFICIAL USE ONLY Mexico Country Assistance Strategy Table of Contents I. Introduction .1 II. Economic and Social Context. 2 lII. Mexico's Development Agenda .................................................4 IV. Economic Outlook and Risks. 7 V. Mexico-Bank Group Development Partnership ............................................... 10 Growth with Stability ........................................... 10 Social Development ........................................... 16 Modernization of the State .18 Portfolio Management ........................................... 19 VI. Instruments of Partnership ................................................. 20 VII. Size of Bank Group Program, Country Risk and Creditworthiness .......... ........ 22 VIII. Collaboration with Other Organizations ................................................... 25 IX. CAS Priorities, Success Criteria and Risks ................................................. 26 X. Agenda for Board Consideration ................................................ 27 Annexes 1. Bank Portfolio Matrix 2. Bank Program of Lending and Non-Lending Services 3. Bank Fact Sheet 4. IFC Portfolio and Investment Program 5. Economic and Exposure Indicators 6. Mexico at a Glance Attachment Private Sector Strategy Paper This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed wiLhout World Bank authorization.  LIST OF TEXT TABLES, C-HARTS, AND BOXES Table 1: Summary of Economic Indicators Table 2: Summary Indicators of External Exposure Table 3: Mexico Country Assistance Strategy Matrix, 1997-99 Table 4: Alternative Bank Lending Scenarios Chart 1: Incidence of Poverty Chart 2: Bank Exposure Ratios Box 1: Bank Group's Crisis Response in Mexico: An Update  MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE UNITED STATES OF MEXICO I. INTRODUCTION 1. The FY97 Mexico CAS is the first to be prepared under the new CAS procedures being piloted Bankwide, and is also the first joint Bank-IFC CAS. It contains several innovations and new emphases: * This CAS has been prepared with a view to making this document the main driver of the Bank Group' country program, the central tool for our partnership with the client and for managing our resources in the service of client needs and priorities. 3 The new CAS emphasizes a shift of focus from inputs-projects, reports-to outputs-results on the ground. It does this by: defining development objectives and strategies in key areas of Bank Group support with greater clarity and specificity; and establishing benchmarks against which to measure progress. The specific instruments of support the Bank Group will deploy-lending, investments, guarantees, advice, portfolio management-and the related allocation of our budget are articulated within this more strategic and results-oriented framework. * Bank and IFC programs are integrated within a unified strategic framework. A jointly prepared Private Sector Strategy paper (Attachment 1) spells out in more detail key elements of the agenda for private sector development and Bank-IFC collaboration. * The CAS has been formulated through a more participatory process involving the client. It will be a 'living" document, with the strategy, performance benchmarks, and our instruments of support evaluated, together with the client, against actual results and adapted as necessary. * The development agenda and the Bank Group assistance strategy are defined in a more thematic framework, focused on three core themes of growth with stability, social development, and modernization of the state, all linked together by the overarching objective of this CAS-raising human welfare and reducing Mexico's high poverty. "Bank Group" in this document refers to both IBRD and IEFC while "Bank" refers only to the former.  2 Improving portfolio quality is an emphasis that cuts across the proposed strategy, and will be supported by another important innovative dimension of the CAS-the decentralization of the Bank's Mexico Department to the field. This change will help improve project implementation; allow a closer, more proactive policy dialogue; and facilitate stakeholder participation. IFC also is strengthening its field office. 2. The previous (FY95) CAS focused on the causes of the 1994 financial crisis and the Bank Group's response in the short term. This CAS has a longer horizon, addressing the challenges Mexico faces over the next several years in its transition from crisis to healthy growth. It spans the remainder of the term of the Zedillo Administration, which ends in the year 2000. Lessons learned from the crisis underpin the strategy for the future. II. ECONOMIC AND SOCIAL CONTEXT 3. Mexico has responded to the financial crisis that erupted in 1994 with a strong adjustment program. The Government's program has comprised: a substantial tightening of monetary and fiscal policies; a large exchange rate adjustment through moving to a floating exchange rate regime; steps to deal with the severe distress in the banking system; initiation of further structural reforms (in social security, deregulation and privatization); and measures to strengthen the social safety net to cushion the impact on the poor. The Government program has been supported by a large international financial package. 4. Thanks to this adjustment effort, Mexico has made substantial progress in a relatively short period of time in restoring financial stability and creating conditions for a resumption of growth. Fueled by improved competitiveness resulting from the exchange rate adjustment, resurgent exports have drastically cut the current account deficit, correcting a fundamental imbalance underlying the 1994 financial crisis (Table 1). Inflation is on a downward course, dropping from a monthly peak rate of 8 percent in April 1995 to an average of 1.5 percent in recent months. The reduction of inflation has allowed the peso to stabilize and interest rates to decline, with the annual rate on the benchmark 28- day cetes falling from a peak of around 80 percent during the crisis to around 25 percent in the past two months. Improved investor confidence is reflected in progress in restoring Mexico's access to international capital markets, which has permitted Mexico to refinance some of its external obligations on more favorable terms and, together with the international assistance package, rebuild foreign reserves. 5. The crisis and the adjustment it necessitated led to a sharp contraction in economic activity in 1995, with GDP falling by as much as 6.9 percent, domestic fixed investment plunging by 30 percent, and formal sector unemployment doubling. But a recovery is now under way, led by exports that continue to grow strongly and supported by an incipient revival in domestic demand as adjustment policies succeed in restoring financial stability. On present trends, GDP growth of around 3 percent is expected for 1996.  3 Table 1: Summary Economic Indicators Actuals Est. Projected 91-93 94 95 96 97 98 99 2000 Average Real Growth Rates %): GDP 2.4 3.5 -6.9 3.0 3.5 4.0 5.0 5.0 Exports (GNFS) 3.3 7.3 28.4 16.5 8.4 8.2 8.0 7.0 Shares of GDP (%): Gross domestic investment 23.7 23.5 19.4 19.2 20.6 21.9 23.7 24.2 Gross national savings 17.4 16.0 18.7 17.9 19.0 20.0 21.6 22.1 Non-financial public sector balance 0.4 -0.4 0.1 -0.7 -1.0 -0.6 -0.3 -0.3 Current account balance -6.3 -7.8 -0.3 -1.2 -1.6 -1.9 -2.1 -2.1 External debt 35.9 36.1 64.4 54.9 52.3 49.5 46.2 42.5 Other: Annualinflation(CPI,endofyear)(%) 12.9 7.0 51.3 27.0 12.5 9.0 7.0 5.0 Real exchange rate (annual change, depreciation +) (%) -7.6 3.8 45.2 -11.7 -- - - - Gross intl. reserves/imports (mos.) 5.5 1.3 4.4 3.2 3.1 2.7 2.4 2.5 Debt service/ GNFS exports plus current transfers (%) 41.2 36.4 43.3 48.9 38.6 41.4 41.9 39.4 6. This improving outlook is contingent upon continued firm implementation of the Government's adjustment program. While investor confidence has recovered, it remains fragile and vulnerable to policy slippages and shocks. Also, the banking system problems remain a major concern. With the decline in interest rates and the upturn in economic activity, bank portfolios, afflicted by large non-performing loans, are beginning to stabilize. Government efforts in support of bank restructuring have helped strengthen bank capital positions and improve accounting practices and prudential controls. Nonetheless, the banking system remains fragile. Fiscal costs associated with the various Government bank support programs are currently estimated at around 9 percent of GDP in present value terms, and will be a source of pressure on an already tight fiscal position. 7. The recession in 1995 in all probability increased the incidence of poverty, from levels Chart 1: Incidence of Poverty that were already high. High poverty rates have (% of population) persisted nationally, but they are especially high 40 in rural areas (Chart 1). The poverty picture is reflected in a highly unequal distribution of 20-K income; in 1992, the bottom 20 percent of the I0 population received only 3.8 percent of income compared with 55.6 percent by the top 20 N tml Urbm RU percent. Reducing these high levels of poverty Source Wodd Bank, Mexico Pover Assessment, 1996 and inequality is essential, not only on grounds of human welfare and equity but also to preserve social stability without which sustained economic progress cannot be achieved. The growth process needs to involve, and draw on the productive potential of, a broader mass of population and the lagging regions. Poverty is highly concentrated in the southern states, and it was rebellion in one of these states-  4 Chiapas-that contributed to the economic instability in 1994. The recent rash of rebel activity originated in another poor southern state-Guerrero. Whatever may be the specific political factors associated with such unrest inimical to national stability, poverty provides a fertile ground for it. The rise in unemployment and the erosion of living standards caused by the recession are reflected also in a general increase in crime. Social discontent could mount if the still fragile economic recovery falters, raising the stakes for Mexico to consolidate and build on the recent economic gains. 8. Political reforms-democratization, decentralization, rule of law-are a major element of the Zedillo Administration's agenda. These reforms will strengthen public institutions and are necessary for stronger, stable growth and more effective poverty reduction programs in the long run, but inevitably add to uncertainties in the short run. President Zedillo faces strong resistance from entrenched interests, including from within the ruling party, to these reforms. Against this background, an important recent achievement is the enactment of a major electoral reform that supports the transition toward a more pluralistic political system. This reform will provide a more level playing field to political parties in the congressional elections scheduled for July 1997. Opposition parties are expected to strengthen their position in Congress in these elections. Mounting political pressures in the run-up to the elections will test the Government's determination to persevere with monetary and fiscal discipline. Creating a more democratic, open political system is important to another major thrust of the present Administration's institutional reform agenda-devolving more responsibilities to states and municipalities. Unaccompanied by effective democratization, decentralization runs the risk of decentralized authority being captured by powerful local elites. III. MEXICO'S DEVELOPMENT AGENDA 9. The reforms of the mid- to late 1980s and early 1990s reoriented the economy toward market-led growth and international integration, and redefined private and public sector roles. Yet they did not deliver the expected rapid growth, poverty reduction and improvements in social welfare. Lasting macroeconomic stability also was not achieved, as the 1994 crisis makes clear. Why? Structural reforms, though significant, did not go far enough in mobilizing savings and increasing productivity, the fundamentals of growth. Domestic savings in fact declined. Macroeconomic management, though improving, was not consistent in maintaining monetary and fiscal discipline, external competitiveness, and prudent debt management. Financial stability and efficient resource allocation were undermined also by banking system weaknesses, reflecting a deficient incentive, regulatory and supervisory framework for banks. Public institutional weaknesses undermining the quality of governance blunted the edge of expenditure programs aimed at poverty reduction. How can Mexico do better? Analysis suggests the need to: * pursue sound macroeconomic policies in a consistent and sustained manner, reducing Mexico's vulnerability to periodic financial crises;  5 * extend and deepen the structural reforms that Mexico has been implementing- opening up markets to true competition, increasing private sector participation in the economy, mobilizing domestic resources, reforming the financial system; and * initiate new, second-generation reforms, with a focus on strengthening the institutional foundation for growth and development. 10. The central, overarching development objective is a broad-based improvement in the level of human welfare and reduction of Mexico's high poverty. This implies a development agenda with three core, interrelated themes: growth with stability; social development; and modernization of the state. Mexico's development strategy, articulated most recently in the National Development Plan 1995-2000 (the sexenio of the Zedillo Administration), captures this agenda well, emphasizing the same core themes. The Bank Group agrees with the thrust of the Government strategy and the CAS outlines the development agenda, in common with the Plan document, within a framework defined by these three themes. The Country Strategy Matrix (Table 3) identifies the main performance issues in each of these thematic areas and outlines how the proposed development strategy would address the identified issues. 11. Growth with Stability. Moving Mexico onto a higher and sustainable growth path is indispensable if serious inroads are to be made into Mexico's persistent and widespread poverty. A first priority is to consolidate the still fragile economic recovery. At the same time, reforms must continue that will support stronger growth in the medium term. Key elements of the agenda are: * Maintaining fiscal and monetary discipline to underpin macroeconomic stability, together with an exchange rate policy that supports competitiveness. * Strengthening the fundamentals of growth-saving and productivity. Key to mobilizing domestic savings to support higher investment will be: raising public savings, including through tax reform; and boosting private savings through successful completion of the pension system reform the Government has initiated, and sound development of financial/capital markets (especially rapid restoration of confidence in the banking system). Areas of emphasis in raising productivity will be: removing regulatory (trade, domestic and foreign investment) barriers to efficient private sector development, at federal and lower levels; fostering a competitive environment for small and medium-scale enterprises; strengthening infrastructure, especially through increased private investment; making labor markets more flexible and upgrading education and training; and improving the functioning of agricultural markets. * Fostering longer-term sustainability of growth through improved environmental management, moving beyond the introduction of regulations to the promotion of necessary investments in environmental infrastructure and the development of institutions (national and local) and markets for sustainable development.  6 12. Social Development. Stronger growth is essential to reducing poverty and inequality, but programs targeted to the poor also are necessary. Poverty in Mexico has remained persistently high, especially in rural areas where the incidence of poverty is almost twice as high as in urban areas, indicating that the programs adopted so far have not been very successful. A two-pronged effort is needed for greater effectiveness: * Better targeting and improving the quality of basic social services-education, health, nutrition, safety nets. At about 55% of federal programmable expenditure, social sector spending in Mexico is large. The main challenge is increasing its effectiveness and efficiency. Recent initiatives by the Government to better target food subsidy schemes, improve social safety nets for the rural poor, and restructure the Solidaridad program that supports basic economic and social infrastructure development (including a major decentralization of the program, recently renamed Programa de Bienestar, to the municipal level) are important steps in that direction. * Promoting in an effective and sustainable way the productive sector in the poor areas, especially the southern states, to expand income-earning opportunities for the poor and thereby break the vicious circle of poverty-through agrarian reforms, development of rural financial markets, stronger private sector and community (including women, indigenous people) participation in the development of productive activities (agriculture, forestry, rural industry), and provision of basic infrastructure. 13. Modernization of the State. The agenda for reform in the coming years will be increasingly institutional in nature. An example is the financial sector. Past reforms focused on liberalization of controls. The next set of reforms must focus on strengthening prudential regulation and supervision, accounting and reporting standards, and bank management. Similarly, deregulation of controls on private investment and commerce- domestic and foreign-must be supported by legal and judicial reforms to provide a level playing field, ensure enforceability of contracts, and establish the rule of law. Such institutional reforms are essential to consolidate and make effective earlier reforms. In many countries, including Mexico, liberalization unaccompanied by timely institution- building contributed importantly to the banking system crises that developed. There are similar issues with respect to the machinery of government itself: the main problems with many public expenditure programs are not due to a lack of funding but institutional deficiencies. Compared to earlier reforms, institutional reforms would be more complex and painstaking: for example, it is easy to tear up interest and credit controls but a lot harder to develop good regulatory and supervisory systems and train management and staff. The institutional agenda, accordingly, will have two main thrusts: * Strengthening the institutional underpinnings of markets to ensure they function efficiently and equitably-institution-building in the financial sector; accounting, auditing, and reporting standards; commercial laws (property rights, bankruptcy, securitization); judicial reform.  7 Modernizing public administration to improve the quality of governance and increase the effectiveness of public programs, e.g., improving the efficiency and transparency of the budget system, upgrading the civil service, and decentralizing responsibilities to state and municipal levels where that would improve service delivery-basic social services, local infrastructure-backed by steps to strengthen fiscal and institutional capacities and accountability at these levels. IV. ECONOMIC OUTLOOK AND RISKS 14. Base Case. The next few years represent a crucial transition for Mexico-from crisis to sustainable growth. Given steady progress on the above agenda, Mexico can build on its recent gains in stabilizing the economy and restoring growth. Growth in the next 2-3 years will likely be moderate, averaging around 3.5 percent, with economic fragility diminishing but continuing for much of this period. Provided Mexico successfully completes this transition, growth could rise to a higher plateau of about 5 percent in later years (projections are summarized in Table I and detailed in Annex 5). The projected gradual rise in growth assumes that it will take time for gains in macroeconomic stability and market confidence to solidify and private investment to rebound, the banking system to return to health, and the structural and (especially) institutional reforms to bear fruit. 15. As imports recover with economic growth, the current account deficit will widen again. But if Mexico maintains the new dynamism of its exports by not allowing the competitive advantage conferred by the peso depreciation to be eroded, the deficit can be contained to below 2 percent of GDP, consistent with an improvement in Mexico's external debt indicators in the medium term. Besides containing the rise in external debt, Mexico is taking steps to improve its maturity profile. Debt service, nevertheless, will remain high in the next three years, especially in 1998-99 when the bulk of the crisis- related financing Mexico received is to be repaid, keeping the reserve position tight. To support faster growth, domestic investment will need to increase, but is projected to be financed mainly from higher domestic savings. The base case assumes that three fundamental lessons of the recent crisis-the need to maintain a competitive exchange rate, raise domestic savings, and prudently manage public debt-are well understood. 16. The base case economic outlook depends crucially on an orderly resolution of the banking system problems. The Government will need to move vigorously on the next phase of system reform (para. 30). A related challenge will be in fiscal management. Budgetary costs of bank support programs, together with the transitional fiscal costs of social security reform, could add up to 2.5-3 percent of GDP in each of the next several years. These additional expenditures will need to be absorbed without relaxing the fiscal discipline Mexico must maintain as part of its stabilization program. 17. High Case. The growth outcome will depend fundamentally on the pace and comprehensiveness with which Mexico pursues the development agenda outlined in Section III. A real opportunity exists for achieving higher growth than forecast in the base case: the country's development potential is immense; major new growth opportunities are  8 offered by NAFTA; and substantial structural reforms have been implemented since the late 1980s which have yet to yield their full growth dividend. An aggressive reform effort, that removes constraints to higher and more efficient private investment, can tap this potential, permitting growth to exceed 5 per zent toward the end of the decade and allowing a faster reduction of poverty. Such ar. upside scenario has a parallel in Chile's experience, where the reform momentum triggered by a crisis similar to Mexico's helped put the country on a markedly higher growth path following the initial adjustment phase. 18. Low Case. The base case economic outlook is subject to two main risks: strains in the banking system; and the vulnerability of the Government's reform program to social and political disruption. A collapse of the banking system has been averted, but the crisis has left behind a highly fragile system. Improved macroeconomic conditions should contribute to a strengthening of bank portfolios, but a renewed deterioration is possible if the economic recovery falters or if the Government fails to press ahead with financial sector reform. On the political front, the Government's adherence to a tight stabilization program in the face of a steep recession provides a reassuring demonstration of its commitment to adjustment. Nonetheless, political pressures will continue to test the Government's resolve, especially in the run-up to the 1997 elections. 19. A downside scenario was developed to examine the implications of an interplay of these risks. It assumes that a lack of political will keeps the Government from aggressively pursuing the agenda for restructuring the banking system and weaning it from public support. Fiscal costs of bank and debtor support continue to mount, reaching 15 percent of GDP in present value terms (they are assumed to be contained to about 10 percent in the base case). These higher costs show up as a rise in the fiscal deficit as political difficulties render the Government unable to absorb them without relaxing fiscal discipline. This sets off a vicious cycle of a renewed rise in inflation and interest rates, declining investor confidence, and a narrowing of access to foreign capital. With the rise in inflation, the peso initially appreciates in real terms but becomes increasingly vulnerable to volatility as investor confidence dips. The recovery from the crisis is protracted, with growth stagnating around 2 percent in the next 2-3 years. Mexico is able to continue to meet its external debt service obligations, but at lower income and import levels. An additional risk in this scenario is that the economy remains vulnerable to shocks over an extended period. 20. External Environment. Mexico's integration into international trade and capital markets has increased appreciably since the late 1980s. This brings important benefits- wider markets for trade, increased access to foreign capital and technology. But it also confronts policymakers with new challenges, as Mexico's experience vividly demonstrates. Especially important is the need for stricter discipline in macroeconomic management, including sound financial sector management, given the increased mobility and potential volatility of capital. For Mexico, with increased international integration, the payoffs to sound policies are larger, but so are the penalties for policy errors. 21. Mexico's exposure to external shocks-developments in export markets, foreign interest rates, capital flows-is sizable, but the country has taken steps since the 1994  9 crisis to reduce its exposure and vulnerability to such shocks. First, the surge in exports fueled by the restoration of a competitive exchange rate has substantially expanded the export base. Oil, whose price is particularly subject to volatility, remains a major source of exports and fiscal revenues, but its contribution has now dropped to 15-20 percent from around 30 percent in the mid- to late 1980s. Second, the large reduction in the current account deficit has reduced Mexico's dependence on capital inflows. Third, Mexico has been able to improve the maturity structure of its external debt, reducing its reliance on the more volatile short-term portfolio flows. The accumulated stock of nearly $30 billion in dollar-indexed short-term domestic securities (tesobonos), which played an important role in the financial crisis, has all been retired, mostly replaced with longer-maturity external debt. Fourth, the financial cushion available to absorb shocks, virtually depleted after the 1994 crisis, has been strengthened, through replenishment of reserves and restoration of access to international capital markets. A decline in external risk is also indicated by some summary exposure indicators shown in Table 2. Despite these improvements, however, Mexico remains vulnerable to external shocks, especially over the next three years when the debt service will stay high and international reserves relatively low, requiring strict adherence to prudent macroeconomic policies. 22. New trade opportunities created by NAFTA are a key element in Mexico's export prospects. But NAFTA also brings challenges: firms must become more flexible and efficient to stand the test of increased competition, in domestic as well as export markets. With closer integration, the sensitivity to the U.S. economy rises. About three-quarters of Mexican exports now go to the U.S. A strong resurgence of protectionist sentiment or a marked slowdown in growth in the U.S. market would have important implications for Mexico, though both appear unlikely at this time. U.S. electoral politics may temporarily slow the implementation of some aspects of NAFTA in 1996, but a serious backtracking on the agreement is considered unlikely. The medium-term growth outlook for the U.S. economy remains positive. At present levels, a 1 percent decline in U.S. GDP is estimated to lower Mexico's total exports by around $1 billion. As Table 2 indicates, another source of sensitivity to developments in the U.S. economy is interest rates. Some rise in U.S. rates in the period ahead is likely, but current forecasts do not point to a sharp surge. Table 2: Summary Indicators of External Exposure Source of Shock Magnitude of Shock' Annual Impact of Shock2 (% of exports) 1994-96 1997-99 Terms of Trade 4.3% deterioration 6.2 6.5 International Interest Rates 290 basis points rise 3.6 2.4 Manuf. Export Volume 5.7% decline 2.7 3.1 Private Capital Inflows (excl. FDI) $8.4 billion decline 11.9 8.0 Total3 24.4 20.0 TMeasured as one standard deviation of three-year moving average of time series for past 10-15 years. 2Impact, in terms of exports of goods and services, of deterioration in the shock variable from the base case path over the three-year period by the indicated magnitude. 3These shocks are unlikely to occur simultaneously and so their impact is not additive, the total is shown merely to illustrate the change in overall exposure to these shocks over the two periods.  10 V. MEXICO-BANK GROUP DEVELOPMENT PARTNERSHIP 23. The Bank Group assistance strategy for the next three years has been designed, in consultation with the Government, to support key elements of Mexico's development agenda outlined in Section III. The CAS Matrix (Table 3) maps Bank Group assistance strategy into the three core themes of this agenda-growth with stability, social development, and modernization of the state, all linked together by the overarching objective of raising human welfare and reducing poverty. The matrix relates Bank and IFC instruments of support to the main elements of this strategic framework and defines benchmarks against which performance will be monitored. While details of the country assistance program are in the CAS Matrix, key features of, and issues in, the program are highlighted here. Four features cut across the program: * As Mexico is likely to remain in a difficult state of transition from crisis to sustainable growth for much of the next three years, part of Bank Group operations will continue to focus on the short term and assist the Government in dealing with the crisis and its effects (Box I provides an update on the Bank Group's crisis response). Increasingly, however, the Bank Group will focus on operations that will help lay the basis for stronger growth and speedier reduction of poverty in the medium to long term. * The agenda for private sector development will be pursued through more focused, concerted Bank and IFC efforts, utilizing the framework of a jointly prepared Private Sector Strategy (PSS, Attachment 1). While Bank-IFC collaboration will span a broad agenda for private sector development, key areas of collaboration over the next three years, as detailed in the PSS, will be: banking, capital market, small and medium-scale enterprise restructuring, infrastructure, and regional development. * A major emphasis across the Bank portfolio will be to improve portfolio quality and results on the ground-through better quality at entry and improved implementation. * IFC will focus more on small and medium-scale enterprise development and ensure that its operations catalyze and not displace private investment. Growth with Stability 24. A large part of the Bank Group lending and non-lending program over the next three years will support the fundamentals of sustainable growth: sound macroeconomic management, higher savings and productivity, and improved environmental management. 25. Macroeconomic Management. Supporting sound macroeconomic management and financial stability will remain a major focus for the Bank. The Bank has stepped up its macroeconomic monitoring. In combination with enhanced surveillance by the IMF and more timely provision of economic data by the Government, this should help institute an improved warning system for any emerging problems and assist in contingency planning and policy dialogue. While the IMF will lead the dialogue on the stabilization program and  11 exchange rate and liability management, the Bank Group will concentrate on issues relating to savings, investment and productivity; public expenditures; and financial sector management. Policy dialogue in these areas will be underpinned by analytical work carried out in the framework of both the ESW program and related lending operations, and supported by an enhancement of Bank analytical capacity. Box 1: Bank Group's Crisis Response in Mexico: An Update Financial Sector Restructuring. A Financial Sector Restructuring Loan ($1 billion) has supported a substantial sector adjustment program. Bank supervision has been close. Measures supported by the second tranche released in July included: implementation of revised accounting standards for banks and other financial institutions that will assist supervisors in better assessing the condition of banks and also strengthen market-based supervision by providing investors with more transparent information; and issuance of revised capital rules for brokerage firms and agreement on an implementation schedule for credit exposure limits for development bank lending to commercial banks. Through an operation approved in July, including up to $100 million of IFC's own resources and up to $200 million in syndicated financing, IFC is helping Banamex, the largest commercial bank, develop a loan restructuring facility for viable medium-size enterprises. Essential Social Services Loan (PROSSE). Out of a loan of $500 million, disbursements totaled $302 million by July. Under the loan, the Government committed to two courses of action: potecting budgetary allocations for high priority social programs targeted to the poor; and initiating a system of monitoring and evaluating social expenditures to increase their efficiency. PROSSE-related budget allocations rose from 5.67 billion pesos in 1995 to 8.76 billion pesos in 1996; and the finance secretariat has established a monitoring and evaluation unit for social expenditures. Privatization Technical Assistance Loan. Disbursements have so far been modest under this $30 million loan, largely due to delay in privatization in electricity (the largest component of the loan) and secondary petrochemicals. But other pnvatizations are broadly on track-in telecommunications, railways, ports and airports. As the divestiture process winds down, greater attention is being given to regulatory and cross-sectoral issues. Portfolio Restructuring. Since the 1994 crisis the Bank has restructured a number of projects with partial cancellations of about $860 million. Projects involving on-lending, especially in environment, were affected due to the reluctance of states/municipalities and private enterprises to borrow at the high interest rates prevailing in Mexico. Social sectors also were affected, due to the reduced dollar amounts needed to support the same level of peso expenditures and revised priorities following the crisis. Non-Lending Services. The Bank has stepped up macroeconomic monitoring, and both the Bank and IFC have increased non-lending activities, including analysis of financial sector and enterprise restucturing issues and new approaches to addressing the problems of the poor southern states. 26. Raising Savings and Productivity. Strengthening these fundamentals of growth will motivate much of the Bank Group program in finance and private sector development. 27. Strengthening the Tax System. Part of the increase in national savings must come from higher public savings. Restraining expenditure growth and improving expenditure efficiency will remain important, but tax reform to raise more revenue also will be necessary. This is particularly so given the large new expenses the Government faces in the years ahead because of social security reform and banking system support (para. 16).  Table 3: Mexico Country Asistance Strategy Matrix, 197-9 (1) Deve _togrmeatObjedIveniIsS Diagnosis Strstl/Aetlaei a Pr|gres eensartr IBRD lIFbsC Oerrdsia D pm Objceisc R sg ce eof h o s e faAci adreseig p.-. Indds fpoey tobe radanedb y 3 3prds ipsine by 1_999(ltess 34% s m 2). GROWrIf WITH STABILITY La of a sablem nsaconnsc * Policis wporng financial ability no MN bsl M _ereenno Statlev fouodtieto oompdit_iven not followed consistently, cpeciallyin . Adtha to mnaonmic polices suppoitr offunancial . Compliance with IMF sthbilization pogrn. Anald CEMs the oentet of inceased aid morc volatile intemational sablity. oDVptitiv,s and iuainble growth. * GDP gawth arosun 5% by 1999. Maco Policy Dialoguc, capital flovm . Iaimn below 10% by 1992 Policy Notes, Monitoring Finacial stability siderninad also by serious banking * Promote sound financial teete developmenst (see below). * Average expesi growthi at twimc GDP growth rate or mor in 1997-99 sysitem weakn (reflectingdficiet incentive, * Gross national uvings 22% ofGDPby 2000 (6%r in 19994). regulaoey an aprvisory hamnew-k). Low anid utable growth GDP Weakfundaonental'gofrowil: Str dtes ltFmanamnatals of Grwth geweonly 3% pa over the 5 Year LDW nd declining lsaing re. (a) MoWs. Saing. preceding the muds fiaa cri (2% if averaged ore 10 yean), and - Inadquate miobilization of public saving . F'lI Potbt( plumgec 6.9% in 1995 ass rut of induming troub the tax ystem Increase pubic stving, rcomneit tax systm towrd * Broadren VAT base; increase VAT revenue to GOP ratio. CE on Savings (97) the aisis. conraumpn - Disincentives to private saving lnsam d demed Pe_m Ssn Refonn CtZontr. Savin. 1 (97) TA and equity barenit. PAYG pensim synt. . Shift fom defned-benefit PAYGystem to fully-rlnded, a EnAdment of new Socisl Security Law and legislation govamg pesion CE .on Savings (97) nippo to defined- csoribution ystemn or privstipublic secto fund ianagement, and ofqpprpuite mgulot-y aersework sd Cork Saving 11(92) AFOREs workv in,altment regie for AFORES. Coot. Saving. 11(99 . Support iniplaentation of new pension stn ,iarough . Restructure INFONAVIT. appropriate regultions nd strengthened monitoring nd . Extend penaion refortm to pubik sector workern (ISSSTE). - Fragile ad underdeveloped financial ryem. Fninaeal Stteon Develonment providing inadequa security, accessand a Retre health ofcoranern hanngdsyg tes by: . Adoption of OECD-ooparable disclosure and accounting standards, FSRL I (ongoing) Vatue instrument diversity to aaveenrtnvestors. acrelcrting resolution of troubled banks .d portfolios; prudential regulation, capital rule. BEking ESW (97) Capital inproving prudential regulation and supervision, incentives . Newly stabbihed Asset Disposal Ageicy (VVA) flly functional. Omgoing FAL LoWs and market diipline. I Phae-ut ofcomprheasive deposit inurirnc. FSRL 11(97) ReIuctturing Support development of capital suurhet by: reformnng . Deflne narrower. viable role for Govanment (FOVL INFONAVIT, Guarinteco Equity market for housing fiance; deepeaing sand doersifying FOVISSSTE) in homing fuinanc ESW Invednnsts markets for ecurities. Itmanne of quality mortgage and nm-mortgage-backed securities. a S gtengber f intal mnaket infr.stiructure reform . Functioning collaleral ad credit registries. Ongog FrAL TA support ad gregulaory fr ork f samed ldi upgrde * Cretdraingin tionrelyvilb Disclosureurnloleeloed ESW undarwiting regulatory and superviay fraesework of secufities msarkets; Cr draigifntonedlyviabeDscue mN-d ES ftsrhcr dvewlop ancillary financial information suvin on public offtrings. Financ hiab (99) facilities a Enpand ocess to andrifroinicy f rural ~ Pilot progra initialed to inipov delivery of rural fintancial scrviom. Rural Finance TA (97) Varltir . Expunt acess C. and .1ficiency fnuwl tb lmc markets. . Phase-ut Goveiment support for BANRURAL und FRA by: Rural Fuiace (99) Capiet Furd liberalizing inirest rates; reducing subsidy dependence inden. . Rationalize the ole of development bansn and improve F Cmp nstution of action pla fo developmest baks agreed nder CEM o Publie Cre( heir finacial viability. FSRLI. Cessio ofit tie tending.  Table 3: Mexico Coutiry Aualttance Strategy Matrix, 1997-99 Drevloj Objttvuln Dhpem StrmteU/Ade- Pajgrami emeebIma C IERD tiC Gmatrally low level d pwib of yodctivi. (b) Iner,se Poductihity - Ld drvlpment ofSME mea of _idret for Paftait Iatrarhm eiAody. roti -wbd by * Feivltestruceraing/d vArkoraexzit Oedf md * Rofam of laiayfmitutibomJ ftmiwak for aOraigFrAL/ESW Ct tlor "goag fIn d ia baai py/lWdiontfq d istastnzatiot PLo lacks (99) TA a * Ewatoc copopi n by apomi c id st gowth ofsME * lnma,4 nm_rkc med fianal fto, to SUEs bnerd SUE mLd POL Study (9t) tOnot: uaep d acor to f teau; tedma ddifam; prtsicipolt toi eapcota. loha ly too -b-a tim& PSD Canpatitivema Vlue rempatoy ro to Wvidl lvd pleyd j TA(9t) captal PFni Strucard Io (badle ad * Emnod tra d in_vtmmi (dami m fodsian) * Fathar manilkatia ofdor tre mi n_thm rm om at Prodivaty CEM (97) foot t dhotifm c1)cki. pivai) douglk dereglaion -id the vmtlaliuiaa p or fmdr%ldwwe/local o. AmIlor _iborm fibaip invtma LPal. tStu (9S) _ lins, mipicud didan gfo _ip orar rno ESW mos coepl aod by y _AI * Rolc oftriff mme inr 1995 pn_ to urtmal PTAL (96) g (_n m _ial -ter)c asn, (at teail, d _tde footwer, btor pr &xiade). Stgafihc pmasregrrnam - pevtada o(ordaiia pmawi cfeaqlt.laoai of m _privatiol ta tionp _ ogrom t an ivatm- p1 itn i_dw lir&amiuotawe m r, (woe below) lack of1opproqut policy -dregltay . Ac _la* redauda md pridnvatmi mianmpt wa * Ipwovoed IelVqlaty fraryfw k fatar privateptrboipation prt, PTAL () pnbtr, Stmewk ff peovatmpmataoaoe. amiu cli raihawyj, aepwa pose, oil and pederal Roeh (97) TA * apo Pllic Newa iadraiructura frnag ewhoirms, (& ford r_ fa tram Ro (97) TAd infintudiidag aftbo 100-erm private finmic at * laryrved tebie -omaqi- mrvnin mandirsia citicOeMCMA. Ww A Smimatima 1 m. i rati foIm'aelevels,;o matra0dwe * Wja to rew Plum prep e 'for 155 ntqmaltoltie; waoe mymemi (ungm,l uK (99r) newly op-nd *_ p1.IU iOyImI at e C.eOd iJS at OA I. mnaoasi pid ed f wa _ S UI(93) mu*ocWa wdw md sa , uub_l mnd _ a r i mur edvalp m rn_ in_it i _a_CM P- pi p- - Ir. Policy NOW Fund - [Aba imt rigidlkm mi back ofs Lmdr u bmiaarg . IIEyrfv ea om fe iaqtoyuai nfaoelsoion.er * Am pwt ofrsocW mmcarty e fda, tw sedge an peyroll vocoL Ccdr. S nmp LUa ata and q ty da bbra rukd iriton rwdaooze (97.93) lbor-ndbtr rGhKI Hef Rdann (99) TrmaingAwaomim,i * Ef_nd acm, to trmn for dirplacc& y wek - Me uorarled wake.m r pvulg .Wo .i tOaough PROBECAT; < w ESW (97) ipoe qutlty ma relv of b tinirgfroua increasad SME wekm, rov kt g t trw* CIMO incrveased oerirprg p- peztipodm p e cerme_mwus cm4he-job traiog * [abor campa y standardsr oeaa psboim Cr3f developed wder iri SUEs. private soda teedala~; iridmpmidmag cutaficf6a -anea attLsiadh AricoaYinar paliadvaty cndri by Ar r D edm unctum lad uamire ari property ringr md * Deveop rural aeleutae markts; ioreae meitty oflmd l lucreadt role of produar mktdiag ortgmizaLiona; ld ESW, Water Vanur iefficmeim/ges i neal diauruae mad teur w er mA propt rit titlioJregsratio oWmided, regdry of waer n8ts *nabimled Mugmm t (96), Cpull 1o&a:er savkm DRD 1 (atpag Mie &M * BMter tapi aaicuhaialx n thArtol . Dimp of paetitive Wow fimd fe rrned ai exmaor co ted. od Clmi P, poje inm wiagn_wre Rwal Pwoty Report e aot-oniAd (97) Ag. PobLiy Nums odMaprim