Mexico - Strengthening Enterprise Finance : Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure

CONFIDENTIAL CONFIDENTIAL Report No.: 17733 ME Report No. 17733 ME Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure GREEN COVER DRAFT September 25, 1998 Mexico Country Department Latin America and the Caribbean Region The World Bank This document has a lesticted distribution and may be used by recipients only in the performance of their official duties its contents may not be otherwise disclosed without World Bank authorization F LE COPY WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 - December 31 CURRENCY EQUIVALENTS Currency Mexican Peso (MexP) US$1.00 MexP 10.130 (Sept.18, 1998) Vice President Shahid Javed Burki Counrty Director Olivier Lafourcade Sector Manager Fernando Montes-Negret PSD Sr. Manager Ira W. Lieberman Task Manager Gary J. Fine PREFACE This study was prepared by a team led by Gary J. Fine, a member of the World Bank's Private Sector Development Department, Small Business Unit. Authors and key contributors to specific chapters included Carlos Cuevas (on micro-finance institutions), Raj Desai (on industrial groups), Olivier Fremond (on securities markets), Leonid Koryukin and Gladys L6pez Acevedo (on enterprise finance), Mike Lubrano (on legal and regulatory issues), and Mario Reyes Vidal (on commercial banking and related issues). Important written contributions were also provided by Joost Draaisma, Roberto Panzardi, Oleg Petrov, Richard Rosenberg, Wendy Jagerson Teleki, and Fausto Trillo. Valuable commentary was received from the peer reviewers, Lajos Bokros and Margaret Miller, as well as from A. Craig Burnside, Jose Carvajal, Rodrigo Chaves, Daniel Crisafulli, Carl Dahlman, Yevgeny Kuznetsov, Ulrich Lachler, Olivier Lafourcade, Fred Levy, Fernando Montes-Negret, Maria Paniagua, Guillermo Perry, Sonia Plaza, Rosalinda Quintanilla, Zia Qureshi, John Soladay, Rudolf van Puymbroeck, and Paulo Vieira da Cunha. In particular, the authors wish to thank Kristin Hallberg and Ira W. Lieberman for their continual guidance and invaluable advice throughout the preparation of this study. The study was based largely on the findings of several missions conducted by the authors and various contributors during the period from March 1996 through January 1998, when several dozen enterprises and financial intermediaries in a number of Mexican financial and industrial centers were interviewed. The study is also based to a considerable extent on enterprise survey and financial data provided by the Bank of Mexico and the Mexican Stock Exchange, and analyzed by Joost Draaisma, Leonid Koryukin and Gladys L6pez Acevedo. The study was conducted under the supervision of Olivier Lafourcade (country director), Fernando Montes- Negret (sector leader), and Ira W. Lieberman (PSD senior manager). The report was edited by Meta de Coquereaumont and Paul Holtz, and processed by Caroline Bouffard-Spira and Mary Dutch. The authors are grateful for the logistical and operational support provided by Dora Posada, Clara Rodriguez, and Andrea Semaan. The findings and recommendations of this draft study are expected to be discussed with the government and other stakeholders in October 1998, and to be finalized shortly therefore. It is hoped that study recommendations will provide the foundation for cooperation between the government and the World Bank in future private sector development activities in Mexico. ABBREVIATIONS ADR: American Depository Receipts BMV: Bolsa Mexicana de Valores CEM: Country Economic Memorandum CFE: Comisi6n Federal de Electricidad (Federal Commission of Electricity) CNBV: Comisi6n Nacional Bancaria y de Valores (National Banking and Securities Commission) CPM: Caja Popular Mexicana CPO: Certificados de Participaci6n Ordinaria GDP: Gross Domestic Product IFC: International Finance Corporation INEGI: Instituto Nacional de Estadistica, Geografia e InformAtica (National Statistics Institute) IPO: Initial Public Offering LBO: Leveraged buyout MMEX: Mercado para la Mediana Empresa Mexicana NAFIN: Nacional Financiera, S.N.C. (National Development Bank) NAFTA: North American Free Trade Agreement NGO: Non-Governmental Organization ODF: Organizaci6n de Fomento PPSA: Personal Property Securities Act SBA: Small Business Adminstration SBIC: Small Business Investment Corporation SHCP: Secretaria de Hacienda y Cr6dito Piiblico (Mimstry of Finance) UCC. Uniform Commercial Code Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundations of the Financial Infrastructure TABLE OF CONTENTS Page No. EXECUTIVE SUMMARY ................................................................................. . ... . ..... ... 1. INTRODUCTIO ....................................................................................................... 1 Summary of Study's Recommendations......................... .......... ..... ........ ......... Study C overage................................................................................................... 2 Sources of Data and Study Methodology. .................... .......... .............. ... ....... 3 Study O rgam zation .................................................................................. ............ 4 2. RECENT TRENDS IN ENTERPRISE FINANCING................................................. 5 Increased Enterprise Leverage in the Early 1990s......... .................. . ........... ... 6 Large Exporters Increase Borrowings Abroad.............. ....................... ..... ..... 7 Effects of Exchange Rate Policy on Debt Dollanzation....... ............ . ... .. ... 10 International Credit Rises for All Firms during Recovery. .............................. 1 Demand for Domestic Credit Remains Depressed.................. ................ . . ..... 12 Continued Reliance on Suppliers Credit and Internal Funds................... ......... 14 Equity Issues Increase while Domestic Credit Declmes....................... ..... .... 16 Financing Trends and Enterprise Investment Levels............................. .. ... ... 17 Toward Greater Financing Choices for Enterpnses............................... ........... 18 3. INTER-COMPANY FINANCING AND THE GRUPOSINDUSTRIALS............. 21 Organizational and Financial Structures....................... ........... ........ .... ....... .. 22 Equity Financing and Dilution....................................... .................................. 23 Internal Financial Flows and "Surrogate" Financial Markets. .......... . ...... ... 23 Supplier and Customer Relations................................................................ ..... 25 Issues Specific to M exico................................................................................... 27 Maximizing Capacity and Adding Value..................... ........................ ... . .... 27 Implications of Intra-Grupo F ancging.......................................................... .... 29 4. SOURCES OF ENTERPRISE CREDI ..................................................................... 31 Profile of Mexico's Credit Markets.................................................................... 31 A. Domestic and International Commercial Bankmg........................................ 34 Decline in Development Bank Credit.................................................... 35 Current and Prospective Bank Credit Operations................................. 36 Toward Long-Term Banking Stability and Growth..................... ...... . 37 B. Other Secured Asset Fimanc g................................................................. .. 38 L easin g .................................................................... ............................ 39 F acton n g ......................................................................... .... ........... 4 1 C. Institutions for Financing Micro- and Small Enterprises... .................. . ... 42 C redit Un on s................................................................................... .. 4 3 Savings and Loan Societies..... ............................................................. 44 Specialized Microfinance Institutions................................................... 46 5. PRIVATE EQUITY FINANCING .............................................................................. 49 Low Level of Private Equity Transaction Volume............................................. 50 Constraints to Growth in Private Equity Investment............................. .... ....... 51 Broadening Firm Access to Private Equity F ancing............................... ....... 52 6. MEXICO'S SECURITIESMARKET ....................................................................... 57 Sources of G row th....................................................................... ........... ........... 57 The Mexican Stock Exchange............................................................................. 58 Shares Issued Abroad: Amercian Depository Receipts............................ ........ 60 Sm all-C apitalization M arket......................................................... ..................... 61 Obstacles to Equity Market Growth................. .................................................. 62 Money Market and Fixed Income Securities............................................ ......... 65 Building Sustained Investor Demand.................................................................. 70 Securities Market Regulatory Regime......................................... ...................... 73 7. LEGAL REFORMS FOR FINANCIAL SECTOR GROWTH................................. 77 B ankruptcy .................................................................................................. ....... 77 Companies Law and Minority Shareholders Rights........................................... 79 Secured Transactions.......................................................................................... 80 Weaknesses in Legal Enforcement.................................................................. .. 83 ANNEXES A. Characteristics of SelectedGrupo ................................................................. 85 B. NAFIN and BANCOMEXT Activities............................................................ 91 C. Companies Listed Through the MMEX Market........................................... 98 D. Use of Proceeds of IPOs During 1997........................................................... 100 E. Obstacles to the Development of Asset-Backed Securities in Mexico....... 101 List of Boxes, Figures and Tables Boxes: 4.1 Comparison of Scandanavian and Mexican Banking C ses....... .... ..... 33 4.2 Loan Documentation. Needed Reform.............................................. .. 38 4.3 The Mexican Public and Commercial Registry...................................... 41 4.4 Compartamos - Making Microfinance Work.............................. ......... 47 5 1 How Debt Financing Can Broaden the Number of Venture Capital Investm ent.................................. ............. ............................................ 54 5.2 Building Investor Demand: Pre-IPO Sale of Convertible Notes.......... 55 6.1 Obstacles to Issuance of Asset Backed Securities: The Tale of One O fferi g .................................... ........................................................... 6 9 6.2 Broadening Investor Participation in Public Offenngs in Mexico.... .. 72 Figures: 2.1 Mexico vs Other Nine Developing Countries........................ ... ...... .. 6 2.2 Dynamics of Leverage, by Size....................... ............ ....................... 8 2.3 Dynamics of Leverage, by Market Orientation..................................... 8 2 4 Dynamics of the Structure of Liabilities, by Size.............................. . 9 2.5 Dynamics of the Structure of Liabilities, by Market O entation........... 9 2.6 Long-term Debt Dollanzation, by Size....................................... . ... ... 10 2.7 Long-term Debt Dollanzation, by Market O entation.................. ..... .. 10 2.8 Demand for International Bank Credit.................................................... 11 2.9 Excess Demand for International Bank Credit...... ............................... 12 2.10 Demand for Domestic Bank Credit......................................................... 13 2.11 Excess Demand for Domestic Bank Credit............................................. 13 2.12 Mexico: Supplier's Credit as % of Total Liabilities, by Size............... . 14 2.13 Outstanding Credit and Stock Market Capitalization in Real Terms.... .. 17 2.14 Patterns of Change in Real Investment............................................... ... 18 4.1 Interest Rates and Real Outstanding Credit............................................ 34 4.2 U niones de C redito...... ................................ . .................... ...... ..... ... 44 Tables: 2.1 Components of Capital Inflows Financing Asset Growth....................... 7 2.2 Structure of Liabilities of Growing and Non-Growing Companies......... 12 2.3 Financing of Asset Growth in Developed Countries.............................. 15 4.1 Banking System Credit and Deposit....................................................... 34 4.2 Outstanding Credit to Pnvate Sector..................................... ................. 35 4.3 Portfolio Distribution of Leasing Compames........................... ............. 40 5.1 Private Equity Investment in Mexico in 1996-1997........... ................... 50 6.1 M arket C apitalization.............................................................................. 58 6.2 Trading Value by Type of Instrument.. .................................................. 59 6.3 Listed Com panies and Funds................................................................... 60 6 4 N ew Issues of Shares............................................................. ........... ... 60 6.5 MMEX Market Capitahzation....... .............................. ....................... 61 6.6 MM EX Traded Volumes and Traded Values......................................... 62 6.7 Turnover and Turnover Ratios.............................................. ..... .......... 62 6.8 Current and Proposed Listing Requirements......................................... 64 6.9 M arket Value of Fixed Income Securities............... ............................. 66 ANNEXES Figures: B.1 NAFIN Credit Lending Volume.............................................................. 92 B.2 NAFIN Credit.......................... .............................................................. 93 B.3 NAFIN Credit by Tier............................................................................ 94 B.4 Bancomext First and Second Tier Credit.................................. ............. 96 Tables: A.1 Characteristics of Selected Grupos........................................................... 85 B.1 NAFIN Credit Statistics................................ .............. ..... .... ............. 97 Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure EXECUTIVE SUMMARY 1. Mexico requires a modem financial structure which can provide a sufficient volume and variety of financing to satisfy the demands of a broad range of Mexican firms. The country has a large and modem economy which has seen significant growth since liberalization and the opening to trade in the late 1980s. A high concentration of exports among Mexico's largest firms, however, has gained them access to international credit and securities markets, while most firms have had to rely primarily on suppliers credit and their own funds from operations in the absence of sufficient domestic credit availability. Despite encouraging growth in other sources of long-term capital, including private equity funds and a rapidly expanding trading venue for small- capitalization stocks at the Mexican stock exchange, these sources cannot yet meet the financing demands of the bulk of Mexico's companies. 2. The primary intention of this study is to provide recommendations for the reform of the legal and regulatory framework which forms the foundation for all financial sector activities These include reforms in the rules, processes and institutions involved in debt collection, in particular the overhaul of Mexico's bankruptcy law, its system of asset collateralization and the securitization of assets, as well its rules and procedures for reporting, disclosure and corporate governance. Without these essential and long-overdue reforms, the development of Mexico's financial sector will continue to be hampered by uncertain protection of investor and creditor rights and significant informational and institutional deficiencies, and its financial system will continue to be unable to provide the heterogeneous range of debt and equity instruments necessary to financing an economy of its size and diversity. These reforms need to be undertaken with all due haste. 3. Mexico's growth performance since the 1970's, in particular its productivity growth, fell far below international averages. The World Bank's draft Country Economic Memorandum (the "1998 CEM") entitled, Mexico: Enhancing Factor Productivity, compares cross-country findings on the linkage between finance and growth. The study finds that financial sector development contributes to economic growth by stimulating productivity growth, and that financial sector development, in turn, is strongly determined by the legal environment, particularly as it pertains to the legal rights of creditors and shareholders. The study's cross- country analysis reveals that Mexico has a relatively weak legal system and a particularly undeveloped financial system given its level of per-capita income. The CEM goes on to say that "these results are so clear cut that it is difficult to avoid the conclusion that Mexico's legal system poses a major obstacle to financial market development." 4. The clear delineation of contractual responsibilities and the effective protection of property rights which would be afforded by legal and regulatory reform would considerably reduce the perceived risk of lending and investing. This would increase market stability and liquidity, promoting the strengthening of financial intermediaries -- an essential ingredient in spurrmng economic growth through the channeling of savings to enterprises. Reforms would also encourage the recovery of the commercial banking system and the development of new financial vehicles, particularly collateralized instruments such as floating liens and asset-backed securities not commonly employed in Mexico today. Ultimately the beneficiaries of these developments 11 would be Mexican enterprises, which would be provided with increased availability and access to a broader range of financing alternatives. Credit Expansion and Contraction in the 1990s' 5. Mexican companies grew steadily throughout the early 1990s in response to the liberalized trade regime instituted in the late 1980s and the North American Free Trade Agreement (NAFTA) adopted in 1993. Export-led growth had become important to the health of the economy, which had diversified from an historical dependence on oil to a variety of manufactured and agro-industrial goods. The private sector was growing, foreign capital inflows were large and public sector borrowing was down. With the privatization of the commercial banks in 1992 and the easy credit environment that followed -- as large financial groups tended to operate as financial "supermarkets," favoring rapid expansion while risking poor credit performance -- commercial bank lending reached a peak of US $117.8 billion by the end of 1994. 6. Despite the growth in domestic credit markets during these years, large companies, exporters and a number of some small- and medium-scale enterprises increasingly met their credit needs abroad. In part, this was due to the growing international recognition of large Mexican companies and their own newly acquired familiarity with international capital markets.2 In part, it was because international markets provided long-term capital at reasonable rates. Domestic banks responded to the competitive pressure by making longer-term loans -- to companies of all sizes. As a result, by 1994, long-term debt constituted an average of 20 percent of the capital structure of listed Mexican companies, up from negligible levels in the 1980s 7. Since late 1994 domestic bank credit to the private sector has dropped 27.6 percent in real terms. On the supply side, credit volume was affected by the large losses suffered by banks as a result of the 1994 crisis, by a large drop in bank deposits, by banks' reluctance to lend without high levels of collateral coverage (reflecting concerns about the creditworthiness of borrowers and a general risk aversion among banks to increased lending). The demand for domestic credit was constrained by the substitution of international for domestic credit and the slow recovery of non-exporters. Between 1995 and 1997, most firms relied on suppliers credit and internally generated cash to meet their financing requirements. 8. As with commercial banks, leasing and factoring companies experienced fast growth dunng the early 1990s, the result of financial sector deregulation, economic liberalization and expectations of rapid economic growth. But rapid growth in marginal leases prior to 1995 occurred in the absence of adequate controls, both financial and regulatory. Factoring companies were even harder hit, as a large portion of their receivable portfolio could not be collected. Combined with sharp cutbacks in bank credit to these institutions during and after the crisis, these shortcomings caused severe contractions in the operations of leasing and factoring companies. Macroeconomic factors contnbuting to the 1994 financial crisis are well documented in other studies and therefore not a primary subject of this paper 2 The concentration of exports and related issues will be discussed in a World Bank study anticipated in 1999 111 Increasing Duality of Mexican Enterprises 9. The dual nature of performance and financing of Mexican firms became more pronounced during the economic crisis. On one side, large exporters - including the maqula industries along the northern border -- continued to grow and generate export revenue during the recession, accessing working capital and investment financing abroad. The equity of large companies quickly began to recover by the second half of 1995, as exporters began to experience increased earnings and debt-to-equity swaps, the result of bank debt restructuring, which increased equity (but without providing new capital). As 1996 unfolded, the strengthened capital structures of large firms, along with the start of economic recovery, enabled increased borrowing abroad and allowed these companies to recognize greater equity values in both the domestic and international capital markets. 10. This distinction continues today. Large companies continue to raise long-term debt abroad and in the past few years have increasingly issued equities, typically in the form of American Depository Receipts (ADRs). ADRs accounted for nearly half the US$53.4 billion invested by foreigners in the Mexican securities markets in the first nine months of 1997, and for approximately 15 percent of total Mexican equity market financing. Large Mexican exporters will likely continue to rely almost exclusively on international financing. 11. On the other hand, the majority of firms oriented toward the domestic market - mainly in services and other non-tradeable goods sectors - were hard-hit by the recession, and the volume of credit to these firms was restricted by both demand- and supply-side factors. While most did not have large losses related to dollar-debt revaluation, earnings continued to decline until late 1996, a year later than large exporters reported. With inflation and the devaluation of the peso hitting Mexican workers hard, and wages yet to rise to pre-crisis levels, small and medium-size companies that rely on sales to the domestic markets have been slow to recover. Demand for financing from these companies has barely increased, contributing to the stagnation in domestic credit. 12. Whether the nature of the duality of firms is more related to size (small versus large firms) or market orientation (domestic versus export) is difficult to determine. Increasingly, however, a small but growing number of small- and medium-size exporters have been accessing international credit. Unlike their larger counterparts, small and medium-size companies tend to return to domestic financing sources when the loans they solicit from these banks are granted in amounts and on terms with which they are satisfied. This suggests that domestic banks should focus their strategy on fostering their traditional client base of small and medium-size companies. Financing Small Companies 13. Small and micro-enterprises have traditionally been financed in large part by the development banks, particularly NAFIN, through first-tier commercial banks. Second-tier lending by the development banks declined during the crisis, along with the general decline in credit volume To compensate for commercial banks' reluctance to lend, the development banks attempted to increase their direct lending to enterprises, but with limited success. This suggests that demand-side factors were significant determinants of the decline in lending volume during the crisis. iv 14. Working with a network of several hundred credit unions, NAFIN has also historically supported credit programs for micro- and small companies too small to be of interest to commercial banks. Credit unions suffered a substantial decline in portfolio value in recent years as their client base felt the brunt of the recent recession. As a result, most are no longer qualified as first-tier NAFIN lenders. 15 Mexico's smallest companies have, however, long benefited from non-bank financial institutions such as savings and loan societies, which are cooperative institutions with small- business loan portfolios based entirely on peso-denominated deposits. Recent consolidation of these institutions, which fared somewhat better than commercial banks dunng the recession (managing to maintain their average loan portfolio size since 1994), has resulted in a core of stronger institutions. Several analysts also note the need for the development of regional banks to serve rural clients.2 Another type of rapidly growing non-bank financial institution -- specialized, non-regulated micro-finance providers -- has been providing the smallest loans -- often less than US$100 -- to informal-sector entrepreneurs. 16. Large companies have become more active in providing loans, loan guarantees and other assistance to small suppliers and customers. As foreign capital has become increasingly available to large exporters, they have channeled credits accessed abroad to indirect exporters. In some cases, large companies have even channeled development bank credit to small companies. In many ways, this kind of financial disintermediation mimics the pattern of Mexico's industrial groups, which have ensured that the financing demands of their many subsidiaries and affiliates are met through the group's ability to raise capital in international markets. Growth in Financing Alternatives to Bank Credit 17. Lending by the domestic banking sector may have yet to recover, but the development of domestic non-bank sources of capital has been proceeding apace. Markets in short- and intermediate-term notes though still small, have been supplying medium-term peso debt to medium-size and large corporations. A small but growing number of companies have been raising equity capital on the secunties markets, principally through the Bolsa Mexicana de Valores, Mexico's stock exchange. Compared to the pre-crisis penod, when financial markets were moving toward a bank-based system in which large financial institutions combined credit and secunties operations under a single roof, ultimately resulting in the near-collapse of the banking system, recent growth in the secunties markets -- while credit markets continue to stagnate -- tends to underscore the importance of a capital markets-based financial system for Mexico. 18. Despite recent losses related pnmanly to turmoil in the international capital markets, the rapid growth of the domestic secunties markets since the 1994 peso cnsis has demonstrated their viability in terms of raising long-term capital for companies of vanous sizes. This reflects the increased attractiveness of equities, as valuations of individual shares reached post-crisis highs in 1997. The market capitalization of the 195 companies and 306 mutual funds traded on the Mexican stock exchange grew 26.7 percent in dollar terms to US$164.4 billion by the end of 1997, from its low of US$138.7 billion in 1993. The primary market for new issues witnessed an increase in public offerings from three in 1995 to 20 in each of 1996 and 1997. Though still below its pre-crisis high of US$200.6 billion in 1994, growth in capitalization has far outstripped 2 Rural financing issues have not been reviewed in this study given their recent ESW treatment by Chaves (1995) V growth in the consolidated banking system, in which credit outstanding to the private sector in dollar terms has remained nearly unchanged since December 1994. 19. The most significant development for medium-size Mexican companies is the growth of the exchange's secondary board, which is devoted to small-capitalization stocks. Once considered the preserve of companies which failed to maintain primary board qualification, the small-caps market is now seen by many as the exchange's engine of growth. Since the start of the recovery, the market's secondary board has witnessed a sizable increase in trading volume and market capitalization. Much of this increase occurred in 1997 alone, as traded volume in the first nine months of the year reached US$659 million, a 270-percent increase over all of 1996. The secondary board lists 36 companies, of which 16 were IPOs and 20 transferred from the primary board. The challenge now is to provide broader enterprise access to this source of capital. 20 Venture capital funds and other private equity funds earmarked for investment in Mexico have increased their presence substantially during the economic recovery. Despite this, they have been investing very selectively, primarily in the largest companies. Reluctance to invest reflects a variety of factors: a highly selective investment process reflecting the private equity investor's demands for high returns, disagreement over enterprise valuation and owners' reluctance to forfeit even a modicum of control. At the same time, many investors reject minority positions as too nsky given the uncertainty surrounding the legal rights of minority investors. Toward the Further Development of the Financial Sector 21. Findings presented in the 1998 CEM indicate that countries affording high levels of protection of creditor rights have significantly better developed banking systems, and countries that have stronger shareholder rights tend to have more developed stock markets Strong contract and legal enforcement is shown to be positively associated with both strong credit and equity markets. Thus in order to encourage economic growth, domestic financial markets must have the capacity to meet the financing demands of a broad range of Mexican companies Legal and judicial reforms 22. Reforms in the legal and judicial framework underpinning the financial sector are the single most important and most urgent of the recommendations put forth in this study. The legal framework, for example, must facilitate firm entry and exit, guarantee investor and creditor rights and ensure the free flow of enterprise and market information. Credit and investment markets are stifled by inadequate, ineffective, or contradictory laws and regulations. Contracts must be enforceable by an efficient judiciary system. Present shortcomings add to the risks of enterprise financing by making the issue of certain securities complicated or legally uncertain. 23. Bankruptcy reform. The Mexican bankruptcy law, with its complicated and expensive procedural requirements which enable debtors to stave off collection, has made it disadvantageous for lenders to force a debtor into bankruptcy, in effect transferring the rights of creditors to equity holders. While wholesale reform of the bankruptcy law may not be politically 3 Of the USS2.95 billion invested throughout Latin America in the first eight months of 1997, approximately USS500 million, or about 17 0 percent, was invested in Mexico. This number represents very few transactions, however, as two transactions together totalled nearly US$300 million. vi expedient at the present time, several short-term measures could nonetheless be adopted. These include measures to strengthen the judge's hand in bankruptcy proceedings and ensure the rights of secured creditors. 24. Collateral and asset securitization reform. Mexico's system for pledging movable assets as collateral for loans needs to be reformed to accommodate a broader set of secured transactions, including lending secured by equipment, inventories and receivables. This is especially important for small enterprises that do not have the unencumbered real estate that typically serves as bank collateral. Floating liens, enforceable pledges of property and efficient procedures for the recovery of collateral must be adopted. 25. Regulations are needed to enable asset secuntization, which would permit the issuance of asset-backed securities. Such securities would provide an important financing source and would be a welcome securities market trading instrument. Regulations should include rules on standardization of asset quality requirements, rating procedures and issue registration; transfer of legal rights of underlying assets, including the elimination of required expensive and time- consuming notarization procedures; and the clarification of taxation issues. Services necessary for the development of asset-backed securities will also be needed. These include credit bureaus, asset appraisers and trust services. 26. Corporate governance. Mexico's laws governing corporations, partnerships and other legal entities also require broad revision. The lack of clear fiduciary duties of officers and directors to minority shareholders and of appropriate rules preventing majority shareholders from operating companies to their own advantage is an important factor constraining potential minority investment, including venture capital and other equity investors. For this reason many such investors will not invest in Mexico without majority control. 27. Judiciary weaknesses. The courts system in Mexico today is largely ineffective, due to a number of constraints, including the poor quality and training ofjudges, poor court procedures and lengthy appeals processes and a significant backlog of cases. Programs can be instituted to improve the quality ofjudges, and the system ofjudge selection, compensation and training should be reviewed. Deficiencies in training should be noted and a comprehensive program of judge training developed and implemented. Appeals and other court procedures require revision as legal reforms are introduced. Credit and capital markets 28. In the near term, improving the health of the commercial banking system is paramount. The banking system has been stabilized at great fiscal cost. Loan quality remains poor, however, and banks have not been able to generate new, quality productive assets. Trading activities and various tax credits continue to be major sources of bank income, while large losses are still being experienced in core banking businesses. Margins are likely to narrow as inflation declines and competition intensifies, while operating expenses (including network expansion, information technology and personnel upgrading) are likely to rise. 29. Efforts to improve bank credit operations are being fostered by the entry of foreign capital and expertise into the banking system and by the response of Mexican banks to the increased competition for Mexican companies from international banks. While it may take years to develop a sound "credit culture," banks are upgrading credit review processes, debt work-out Vil capabilities and human resources. Mexican authorities have taken steps to strengthen bank disclosure, prudential regulation and self-regulation. Recent efforts include the adoption of a system of accounting closer to international standards (enforced since January 1997). 30 Additional efforts need to be focused in several areas. More needs to be done in establishing minimum standards for credit approval, formalizing valuation rules for debt restructuring, assessing risk positions and redefining related-entity lending. Banks shareholders capital must be improved in quality and quantity, and a sound system of loan-loss provisions must be developed. 31. Several recent reform initiatives would strengthen the banking system. These reforms would (i) eliminate restrictions on foreign ownership of entities that control financial groups, banks and brokerages, including the elimination of the restriction forbiding foreign financial entities from controling the largest banking groups; (u) increase the autonomy of the National Banking and Securities Commission (CNBV), while simultaneously increasing the commision's powers and authority in financial regulatory matters; and (iii) reduce banking distortions and encourage better banking by placing limits on the value of bank accounts covered by deposit insurance. (Under the current regime, deposit insurance is provided to all accounts, regardless of size.) 26 Measures discussed in Chapter 6 intended to broaden and deepen domestic securities markets also need to be taken. Further growth will largely rest on the market's ability to increase liquidity. In most cases, the portion of shares floated on the exchange is insufficient to stimulate active trading. More often than not, this reflects restrictive listing requirements and the reluctance of family owners to dilute their positions. But what may seem like inordinate concern over loss of control is partly a legal concern, as Mexico lacks sufficient shareholder protection laws. Recently, however, there appears to be more willingness among shareholders to allow some dilution of ownership. 27. Increases in stock market capitalization and liquidity will also have a beneficial effect on pnvate equity investment by providing an effective exit (divestiture) mechanism. The recovery of the banking system will provide domestic sources of long-term debt to complement and augment equity investment in firms and to reduce the overall cost of capital of these investments In addition, the broadening of a current taxation rule which eliminates capital gains tax liability on sales of securities listed at the Mexican stock exchange to cover unlisted Mexican securities as well would eliminate a disincentive to investment in the latter. This would encourage increased pnvate equity investment by Mexican taxpayers. 28. The CNBV, Mexico's banking and secunties regulator, needs to advance its preparation of a draft law which is expected to strengthen mutual funds by separating their administration from the operation of banks that sponsor them and by requiring increasing disclosure of their portfolios and independent calculations of net asset values. The draft law would also encourage increased competition in the distribution of mutual fund shares. Recent proposed reforms to increase the powers and authority of the CNBV reflects the high degree of technical expertise necessary in the development of important regulation, such as prudential regulation governing mutual funds. 29. In the near term, the CNBV plans to improve disclosure standards in prospectuses, enforce regulations through increased surveillance and limit the issuance of nonvoting shares. viii Currently proposed reforms would require disclosure of the trading or acquisition of more than two percent of an enterpnse's ordinary capital stock. In the intermediate term, it intends to review trading rules and introduce regulation to protect minonty rights. Additional measures can be taken to improve corporate governance and the protection of minority investor rights. Among efforts such as these, intended ultimately to increase investment demand for securities, the CNBV should not neglect to consider measures to broaden shareholding among small investors Securities markets in countries as diverse as the U.K. and Chile can attribute increases in liquidity to the aggregate securities demand of individual investors. Greater Financing Choices for Mexican Enterprise 36. The Mexican economy is poised for significant growth as it continues to integrate with the global economy and as Mexican companies of all sizes increase their export orientation. Continued reliance on international credit sources will make domestic capital sources more competitive, encouraging greater domestic availability of capital for firms of all sizes and market orientations. 37. At the same time, a broader range of Mexican enterprises can be expected to issue equity both abroad and at home, and Mexican equities will of course benefit as the Mexican economy continues to expand. But the revival of the domestic banking system also is essential for the emergence of a strong financial sector. The long-term growth and sustainability of both credit and equity markets will, however, depend in large part on essential changes in the legal and regulatory framework which underpins the operations of Mexico's financial system. Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure 1. INTRODUCTION 1.1 Mexico has a large and modem economy which has seen sigmficant growth since liberalization and the opening to trade in the late 1980s and the adoption of the NAFTA agreement in 1993. Exports, however, have been concentrated among the largest firms, and through much of the past decade, large exporters have been borrowing from international banks and banking syndicates and selling shares on U.S. securities markets, in the form of ADRs (American Depository Receipts). Although an increasing number of small and medium-size firms have been able to increase their dollar borrowings abroad as they have expanded their export orientation, and the burgeoning maquila industries along Mexico's northern border enjoy a continuous flow of suppliers credit from their U.S. partners, most firms in Mexico have had to rely primarily on suppliers credit and their own funds from operations in the absence of sufficient domestic credit availability since the peso crisis. 1.2 The growth of other sources of long-term capital, including private equity funds and a rapidly growing trading venue for small-capitalization stocks at the Mexican stock exchange, while encouraging, does not yet provide a wide range of financing options for Mexican firms Mexico requires a modem financial system which can provide a sufficient volume and variety of financing to satisfy the demands of a broad range of Mexican firms. As a result of the crisis and constrained by a legal and regulatory framework requiring important reforms, Mexico's financial system cannot provide a heterogeneous range of debt and equity instruments essential to financing an economy of its size and diversity. 1.3 The primary intention of this study is to provide recommendations for the reform of the legal and regulatory framework which provides the foundation for all financial sector activities The study sets out to investigate deficiencies in the protection of the rights of all financial market participants -- creditors, investors, securities issuers and financial intermediaries. The reduction in transaction risk afforded by legal and regulatory reform would encourage the development of new financial instruments and help broaden and sustain investor demand for them. Ultimately the beneficianes of these developments would be Mexican enterprises, which would be provided with increased availability and access to a broader range of financing alternatives. Summary of Study's Recommendations 1.4 The emergence of a strong and efficient financial sector in Mexico -- an essential ingredient in channeling savings and investment to enterprises in order to spur economic growth - - will depend largely on three factors. The recovery of the domestic economy and the strengthening of the commercial banking system are crucial. Mexico's proximity to the large U.S. market and the benefits of its free trade agreements have enabled it to recover rapidly, with exports leading the way to economic growth of seven percent in 1997. Small and medium-size companies not oriented to export sales, however, have been slower to revive, with only marginal increases in credit demand since the crisis contributing to the slow recovery of domestic banks. Efforts to improve bank credit operations, however, will be speeded by the entry of foreign capital and expertise into the banking system and by the response of Mexican banks to the 2 increased competition from international banks. This should result in an increase in domestic credit, with more attention paid to the credit demands of small and medium-size companies. 1.5 The second factor needed for financial sector growth is the development of a range of financing options -- including short-term credit lines for working capital and trade finance, and longer-term bank loans, subordinated debt and equity for investment -- for Mexican firms. This includes the introduction of financial instruments -- particularly collateralized instruments, such as floating liens and asset-backed securities -- not commonly employed in Mexico today. It also requires the continued growth in capitalization of Mexico's secunties markets and the strengthening of market intermediaries to sustain demand for secunties. Much has already been put in place, including the introduction of new, pnvate pension funds, and a new law on mutual funds is in preparation. A number of exchange-related issues, including the modification of listing standards for securities issuers, the elimination of multiple classes of stock and the standardization of debt-rating procedures, still require attention. 1.6 Perhaps most importantly, urgent reform is required in the legal and regulatory framework underpinning Mexico's financial infrastructure. Both the recovery of the banking system and the development of other financing sources is constrained by the lack of a firm legal and regulatory structure which can effectively delineate and protect the property rights of all market participants and provide the basis for the issuance and trading of new instruments. Reforms recommended in this study would increase financial market liquidity by encouraging a reduction in the perceived risks of enterprise lending and investing, thereby enhancing market stability and liquidity, and increasing the flow of capital to firms. These include reforms in Mexico's bankruptcy law, its system of asset collateralization and the securitization of assets, and its rules for reporting, disclosure and corporate governance. Without these reforms, the development of Mexico's financial sector will continued to be hampered by uncertain protection of investor rights and significant informational deficiencies. Study Coverage 1.7 This study looks at various financing trends and sources of capital before, during and after the peso crisis of 1994.4 It focuses in part on the dual nature of enterprise finance in Mexico today; the characteristics of companies that have access to a range of financing sources, both domestically and internationally; and why such financing is not available to the bulk of Mexican companies. The study focuses on domestic credit and securities markets, examining how the lack of sustained demand for equity and debt securities has limited securities market capitalization, and what has been done and still needs to be accomplished to address these issues. 1.8 The study also examines how companies finance themselves internally and in cooperation with other companies, both m the context of parent/subsidiary arrangements and as part of production chain, customer/supplier relationships. Here the nature of suppliers credit, the extent to which it is used and the arrangements under which it is granted are examined, as are the ways in which large companies help facilitate access to financing for small ones. The study reviews other alternatives as well, such as leasing and factoring, private equity investment and Macroeconomic factors contributing to the 1994 peso devaluation and ensuing financial cnsis are well documented in other studies and therefore not a primary subject of this paper 3 mechanisms which have been providing financing at the micro-enterprise level. It also briefly discusses the availability of finance for micro-enterprises and for entrepreneurs operating largely in the informal sector. Sources of Data and Study Methodology 1.9 Despite a near dearth of data on a corporate sector as large as Mexico's, the authors were able to rely on three sets of data. (A fourth dataset, INEGI's annual industrial survey data, would have been of particular use had it been available for years subsequent to 1993.) The first dataset was the annual financial statements of the approximately 200 companies with an equity or debt security listed on the Bolsa de Valores, the Mexican stock exchange. This dataset provided a quantitative look at corporate financial structure on an annual basis, with yearly flows of enterprise financing and investment, covering the period of 1991 through 1996. 1.10 There are several shortcomings associated with the Bolsa data (the only company financial data available) which would encourage some degree of selection bias. In addition to the relatively small sample size, small companies may be under-represented, as they are likely to experience greater difficulties with getting listed than bigger ones. In addition, stock-listed companies may have greater access to other sources of financing than others and may have been willing to take advantage of this factor. Finally, in part due to investor demands and the requirements of exchange listing, only relatively viable companies appear on the stock exchange. A positive aspect, however, is that access to different sources of funds ensures some degree of financing flexibility, allowing a researcher to draw richer conclusions based on the changes in the financing mix. 1.11 The authors introduced by-size and by-export orientation classifications of the companies in the Bolsa dataset. For the former, sales were divided into three size categories, with the 33th and 66th percentiles as the benchmarks. As a result, small companies were classified as those with less than US$50 million in sales and 50 workers; medium-size companies with less than US$250 million in sales and 300 workers; and large companies, those with greater than US$250 million in sales and 300 workers. For export orientation, while companies with no export sales were considered non-exporters, the rest were divided into non-active and active exporters by the median of the distribution of the ratio of foreign-to-total sales 1.12 The second data source was the biannual Encuesta Semestral de Coyuntura (Biannual Survey of Business Conditions), a Bank of Mexico business environment and corporate financing survey of approximately 500 primarily unlisted companies, covering the period of 1993 through 1997. Mostly qualitative in nature, these data provided information on the business environment from the perspective of the enterprise, including managers' assessment of anticipated profits, investment levels and financing costs; the solicitation and granting of loans, and the level of satisfaction with the amount and terms of financing obtained; and the extent of firms' reliance on suppliers credit and internal funds. Companies were divided into small, medium and large according to the number of workers. With 100 and 500 workers as the two benchmarks (no sales or asset values are assigned), these size classifications are roughly equivalent to those employed with the Bolsa data.5 Approximately 49% of the companies in the sample are exporters, defined 5 A comparison of the number of workers among the Bolsa and the Coyuntura companies are not entirely comparable as the Bolsa-listed companies are typically more capital intensive than the mostly unlisted companies -- representative of the bulk of Mexican industry -- included in the Coyuntura data. 4 as having some level of export sales, no matter how minimal. No maquiladora companies are present in the sample. 1.13 The IFC Emerging Markets financial statements data on ten developing countries, including Mexico, were used to compare the capital structure of Mexican companies to their foreign counterparts to highlight differences and similarities in financial sector development characteristics. The timeframe vaned from country to country, covering the second half of the 1980s and the beginning of the 1990s. Based on listed companies, the data have similar deficiencies as the Bolsa data discussed above. 1.14 In addition to these datasets, interviews with approximately 60 enterpnses and 25 financial intermediaries were conducted in late 1996 and 1997 by the World Bank team that prepared this study. Interviews took place m Mexico City, Monterrey and Puebla, in addition to interviews with private equity investors in New York and Washington. 1.15 Finally, the study relied on current World Bank studies on Mexico, in particular the draft Country Economic Memorandum (the "1998 CEM") entitled, Mexico: Enhancing Factor Productivity, which investigates the linkage between finance and productivity growth, reaching many of the same conclusions as this study - in particular the essential need for legal and econonmic reform of Mexico's financial sector. Study Organization 1.16 The next chapter discusses how the financing demands of Mexican companies have been met before, during and after the peso crisis, presenting an overview of the changes in firms' financing mix. The determinants of these changes are addressed in subsequent chapters, particularly m Chapter 4, which discusses the sources of enterprise credit domestically and abroad. 1.17 Chapter 3 focuses on the financing activities of large industrial groups, and their role in facilitating the financing of smaller subsidiary and affiliated firms. Following the chapter on credit sources are two chapters on growing sources of equity capital -- private equity funds (Chapter 5) and the Mexican stock exchange (Chapter 6). The final chapter sets forth recommendations for needed legal and regulatory reforms. Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure 2. RECENT TRENDS IN ENTERPRISE FINANCING 2.1 The private sector in Mexico, divided between a handful of large, outward-looking companies and a large number of small and medium-size firms, has throughout the current decade increasingly displayed a dual financing pattern. By 1997, large exporting companies had come to depend nearly exclusively on credit and equity raised abroad, primarily in dollars, while the service and non-tradeable sectors - comprised largely of small and medium-size companies -- have had to rely on suppliers credit and their own internal funds. These companies still solicit domestic commercial banks for loans, but are most likely only to renew existing credit facilities -- and often only with increased collateralization and guarantees. 2.2 Discussions with financial intermediaries in Mexico confirms the insights gained in interviews with enterprise managers-that little fresh capital has been available domestically for small, medium-size and many large enterprises. Even when capital is available, enterprise owners and managers are reluctant to borrow at high nominal interest rates, with prepayments and commissions further increasing the cost of borrowing. Some businesses simply refuse to increase leverage, despite their predictions of faster growth if they were to borrow. A general reluctance to borrow, in good times or bad, likely reflects Mexico's history of financial instability. 2.3 Nevertheless, an increasing number of small and medium-size companies -- particularly those that have refocused or redoubled their efforts to export (despite the historical low propensity of Mexican firms to do so) -- have been successful at accessing capital abroad, expanding further the dollarization of Mexican private sector liabilities. While domestic credit has stagnated, the market capitalization of Mexican listed securities recovered quickly following an initial steep decline resulting from the peso crisis, enabling an increasing number of small and medium-size enterprises to raise equity capital on the stock exchange. While the number of companies financing themselves in this manner remains small, this development is nevertheless significant, as it highlights the ability of the securities markets to provide long-term capital essential for investment and growth. But ultimately it is reform of the legal and regulatory foundation -- to increase market efficiency by documenting and enforcing the rights and responsibilities of all participants -- which will be required for the broad expansion in financial instruments and markets so needed in Mexico. 2.4 Despite encouraging signs, the Mexican financial sector remains unable to provide the private sector at large with the volume and diversity of financial instruments necessary for investment and sustained growth. The 1998 CEM compares cross-country findings on the linkage between finance and growth. The study finds that financial sector development contributes to economic growth by providing the capital that stimulates productivity growth, and that financial sector development, in turn, is strongly determined by the legal environment, particularly as it pertains to the legal rights of creditors and shareholders. The study's cross- country analysis reveals that Mexico has a relatively weak legal system and a particularly undeveloped financial system given its level of per-capita income. The CEM goes on to say that 6 "these results are so clear cut that it is difficult to avoid the conclusion that Mexico's legal system poses a major obstacle to financial market development." 2.5 This chapter highlights the capabilities and deficiencies of enterprise financing options from the viewpoint of the Mexican firm. It also examines the evolution of enterprise capital structure, the effects of expansion, financial crisis and recovery during the 1990s on enterprise demand for capital, and how those demands have been satisfied. Subsequent chapters will review more fully alternative sources of debt and equity capital available in the dual-track financing environment facing Mexican firms, along with recommendations for needed financial sector reform. Increased Enterprise Leverage in the Early 1990s 2.6 Prior to the opening of the Mexican economy in the late 1980s, Mexican companies relied primarily on internally generated funds or on equity investments by owners or new partners. While domestic bank credit was available, most companies had little access to long- term or non-peso-denominated debt or to publicly raised equity. By way of comparison, Fig. 2.1 sets forth the average ratio of equity to assets -- an important measure of enterprise leverage -- in a sample of publicly traded companies in nine developing countries at similar income levels to Mexico. This measure indicates that Mexican companies on average had considerably lower leverage levels (as indicated by higher equity-to-assets rations) than the nine-country average in the mid- to late 1980s. This can be explained m part by the primary role of the nationalized commercial banks in the 1980s -- to finance the fiscal deficit and state-owned enterprises. Fig. 2.1 Mexico vs. other nine developing countries: equity-to- assets ratio (IFC data). O 75 0 70 - .. .o 0 65 ... - .- 060 . ..... 0055.. ._ _ ..... 055 - *- -=omercountnes S05 .. ..... 4eoZ 0 SO ... - -------- - x 0 345 ... ... ..... . * .. . . . 030 0 - (~~ U (0 r- CD O 0) - N M) ~ U (0 O( W0 go ( 0 0 W0 CO M0 C 01 0M 0 ) ( 0 Im 0 0 ( ' 0 00 01 0) 0) 0 0 0 0 Yea, Source Calculations based on data from the IFC Emerging markets database (average values) 2.7 The economic reform and trade liberalization of the late 1980s enabled Mexican companies to grow and prosper. By the early 1990s, enterprises had become more profitable and were able to rely more extensively on internal funds During this period a growing number of Mexican exporters, to meet their investment needs, began to access longer-term dollar- 7 denominated loans from international commercial banks, and domestic banks responded by making longer-term loans in an effort to satisfy competitive pressures. As a result, as seen in Table 2.1, the proportion of capital inflow associated with asset growth which was represented by long-term debt rose considerably in the 1990s, from 1.5 percent in the 1980s to as high as approximately 30 percent in the 1990s. As recent studies have indicated that growth in GDP is closely related to the proportion of long-term financing in the capital structure of firms (Demirguc-Kunt and Maksimovic, 1996), increased access to long-term debt is a significant development for the growth of the private sector in Mexico Table 2.1: Components of Capital Inflows Financing Asset Growth (percent, median values)6 Period 1980s 1990s Source Short-term Long-term Equity Internal Short-term Long-term Equity Internal Country debt debt investment Funds debt debt investment Funds Argentina N/A N/A N/A N/A 34.9 6.2 23.5 17.7 Brazil 18.8 7.0 64.5 7.4 16.9 9.8 71.7 -1.1 India 44.3 19.8 10.1 19.9 43.3 19.5 0.0 19 8 Jordan 57.7 2.4 18.9 19.8 31.3 0.0 -0.4 30.9 Korea 36 3 23.9 22.4 8.5 48.2 23.7 16.9 7.0 Malaysia 33.7 6.4 26.5 17.6 23.9 2.9 16.3 36.7 Mexico 21.9 1.5 52.4 15.0 18.8 30.1 32.6 20.5 Pakistan 39.9 6.0 5.5 31.8 N/A N/A N/A N/A Turkey 33.4 13.6 33.2 7.5 34.6 7.0 24.9 24.4 Zimbabwe 36.1 3.2 21.9 34.5 30.5 2.2 37.5 26.7 Source calculations based on data from the IFC Emerging Markets database. Large Exporters Increase Borrowings Abroad 2.8 Changes m enterprise capital structure in 1995 and 1996 illustrate the trends in enterprise financing resulting from the peso cnsis and subsequent recession. A significant trend was evidenced by the ability of large companies and exporters to continue to access credit during this period, despite the steep decline in domestic commercial bank credit in the wake of the crisis. This is illustrated in Fig. 2.2 and 2.3, which show the total liabilities (as a percent of total assets) of large companies and exporters peaking in 1995 -- two years after the same leverage measure for small companies and non-exporters reached a maximum and began to decline. 8 6 Table 2 1 shows median values (in percent) of total asset growth financing by inflows on various liability and equity side components The four values may not sum up to 100 percent, as median values are used Median values are more robust to outliers of the distribution than averages. Country-specific penods vary with data availability 7 Company size, categories are small, medium and large, with net sales as the measure of size and with the three groups consisting of equal nuymbers of companies in each year Companies are also divided into three equal groups with respect to export orientation. These are active exporters, non-active exporters and non-exporters 8 Note that the decline in leverage in 1996 does not reflect a decline in new borrowings but rather a substantial volume of conversions of debt to equity by banks during the year. 8 Fig. 2.2: Dynamics of leverage, by size, 1991-1996 0.49 Z048 0 45 0.42 0 394 1991 1992 1993 1994 1995 1996 Year large medium small eX= all Fig. 2.3: Dynamics of leverage, by market orientation, 1991-1996 0 51 047 -1-%0.43___ ___ '0.41 '~0.39 _______ ______ 037 1 0.35 _______ 1991 1992 1993 1994 1995 1996 Year active exporters non-active exporters non-exporters ..X_= all Source for Figs 2.2 and 2.3: Calculations based on data from Bolsa Mexicana de Valores (average values) 2.9 This increase is not surprising, as large companies and exporters, as indicated in Fig. 2.4 and 2.5, respectively, were able to increase their long-term debt as a portion of their total liabilities during 1995 and 1996. These firms continued to access long-term debt abroad, while domestic banks already showed signs a slowdown, with an increased in bad loans evident by 1994 9 Fig. 2.4: Dynamics of the structure of liabilities, by size, 1991-1996 (Bolsa data) 04 03 1991 1992 1993 1994 1995 1996 Year . large E medium 6 small X all Fig. 2.5: Dynamics of the structure of liabilities, by market orientation, 1991-1996 05 1991 1992 1993 1994 1995 1996 Year active exporters M non-active exporters non-exporters .x. all Source for Figs 2 4 and 2 5: calculations based on data from Bolsa Mexicana de Valores (average values) 2.10 Enterprise financial data show that from the early 1990s long-term debt issued by large companies and exporters was in fact increasingly denominated in dollars. Given the decline in domestic bank credit durng and after the crisis, it is reasonable to assume that dollar- denominated debt was primarily accessed from foreign banks. As seen in Fig. 2.6 and Fig. 2.7, by 1996 nearly 80 percent of the long-term debt of large companies and exporters was denominated in dollars, compared with approximately 30 percent for small companies and non- exporters. On closer examination, it is evident that only the largest exporters, a very limited 10 number of companies with significant, in nominal terms, foreign sales, have a much larger component of long-term debts (mostly in dollars) in their liabilities than other companies. Fig. 2.6: Long-term debt dollarization, by size, 1991-1996 0.80 0.70 - 0.60 C X0 50 1:0 10 1991 1992 1993 1994 1995 1996 Year large --- medium -N small =X- all FigE 2.7: Long-erm debt dollarization, by market orientation, 1991-1996 0.80 0.70- 40.60 1 0 10 1991 1992 1993 1994 1995 1996 Year large --a medium -A small -X- all Source for Figs. 2.6 and 2.7. Calculations based on data from Bolsa Mexicana de Valores (average values) Effects of Exchange Rate Policy on Debt Dollarization 2.11 One would expect a tendency towards dollanzation of enterprise debt to be strongest when there is a perceived undervaluation of the exchange rate, which would mean that the expected depreciation of the exchange rate is small (i.e., smaller than the (nominal) interest differential between dollar- and peso-denominated loans.) On the contrary, when one would expect a large devaluation of the currency, one would rather be indebted in local currency, as the 11 interest differential would make up for the increase in pnncipal (as expressed in local currency) after the devaluation actually occurs. 2.12 Following this logic, the increase in dollar-dominated debt between 1992 and 1994 would seem to have resulted from an undervalued peso. The peso, however, was not considered to be undervalued at this time -- quite the opposite, since by late 1994, at least, the peso was considered by many to be overvalued.'o The apparent inconsistency may be explained by the almost fixed exchange rate regime and the firm commitment of the government to stick to that which made that the possibility of a sudden devaluation limited, at least in 1992 and 1993. This may in part have contnbuted to the increase in dollar borrowing during this penod. At the same time, however, this was also a penod of explosive growth in peso borrowing, reflecting the relative strength of the peso. Once the peso was substantially devalued, however, the peso credit boom ended, while dollar borrowing continued to increase. International Credit Rises for All Firms during Recovery 2.13 Demand for international credit by companies of all sizes and market orientations has risen since late 1994, though it has not reached the frenzied levels of late 1993, when even a majonty of small firms interviewed solicited international credit, as shown in Fig. 2.8. Though large companies and exporters continue to solicit international credits far more frequently than other companies, the increase in international bank credit obtained by small and medium companies which have increased their export presence is most significant. This trend is illustrated in Fig. 2.9, which shows that by the second half of 1996, essentially all international credit solicited by small companies were granted, and in amounts satisfactory to them. Fig. 2.8: Demand for international bank credit: % of respondents who requested credit from international sources 1/93 1/93 1/94 11/94 1/95 11/95 1/96 11/96 II97 Period 10 so -~ -U-- -----smal ----------- d .. -*--a-ge Thus we wItness the efforts of certain large business groups to convert signmficant amounts of dollar debt into peso- denominated debt in September 1994, three months before the devaluation, whereas the practice to contract dollar- denominated loans was particularly strong in the second half of 1995, when there was the perception of overshooting and a strongly undervalued exchange rate 12 Fig. 2.9: Excess demand for international bank credit: Respondents who obtained international bank credit and respondents satisfied with the loan amount, as % of solicitors. 70 so 7 0- so -- - - 70 .. . . . . . . . .. - -- - - - - - - - 50 .. . . . . . . 40 -- - - -- 20/- 0 1/93 11/93 1194 11/94 1195 11/95 1/96 11/96 1/97 Period all obtained A- small obtained - 'alt sufficient amount - - - small sufficient amount Source for Figs 2.8 and 2.9 Bank of Mexico, business-environment survey 2.14 The increase in dollar-denominated liabilities tracks the increased number of Mexican firms of all sizes which boast export sales. As firms that export have led the recovery, it is not surprising, as set forth in Table 2.2, that growing Mexican companies today -- not just large companies but medium and even many small ones -- have issued nearly all their long-term debt in dollars. Table 2.2: Structure of liabilities of growing and non-growing compames as determined based on changes n total assets (percent) Type of company Variable 1992 1993 1994 1995 1996 1 All Shrinking Long-term share of liabilities 24 31 26 22 32 Non-peso share of long-term liabilities 7 14 2 20 49 Growing Long-term share of liabilities 43 44 40 53 41 Non-peso share of long-term liabilities 3 24 64 82 95 Source calculations based on Bolsa data. Demand for Domestic Credit Remains Depressed 2.15 As the recovery in the domestic economy has been more protracted, the decline in domestic bank credit has barely bottomed out. A rapid decline in demand for domestic credit during the severe economic contraction of 1995 had not recovered to pre-crsis levels by 1997, as 13 indicated in Fig. 2.10. Companies began requesting less credit in late 1994, with a bottom reached in late 1995 and very limited growth thereafter. Fig. 2.10: Demand for domestic bank credit: % of respondents who requested credit from domestic banks 60 -J --S m l ----d u-- --*----a-- --- 55 4. . . -- -- -- - 45 - - - . . . . . 40 . . . . .I. . . . . . . . . -- - - - - - . . . . . . 3 5 - -- - --- - - - - - :- - - -- - - - - - - -- -- - - - - - - - - - 25- - - -- - - - ---- - --- - --- -- 1/93 11/93 1/94 11/94 1/95 11/95 1/96 11/96 1/97 Period AII mal -6 Medium - Large Source for Fig 2.10: Bank of Mexico, business-environment survey. 2.16 By 1997 most companies that sought domestic bank credit obtained some amount, though not necessanly a satisfactory amount, as seen in Fig. 2.11. While this is particularly true for small companies, it is noteworthy that far fewer companies in 1995 and early 1996 were able to obtain the volume of credit they solicited. Fig. 2.11: Excess demand for domestic bank Respondents who obtained domestic bank credit and respondents satisfied with the amount, as % of solicitors. 60 55 . 00 1/93 11/93 1/94 11/94 1/95 11/95 1/96 1/96 1/97 Period All obta-ned - - Small obtned All sufficient amount Small sufficient amou Source for Fig. 2 11 Bank of Mexico, business-environment survey 14 2.17 Significantly, small company demand for international and domestic credit displays somewhat of an inverse relationship. Small companies appear to solicit demand abroad dunng periods of greatest excess demand for credit at home, and decrease demand for credit abroad as excess domestic demand decreases. Large companies, on the other hand, have increased demand for credit both internationally and domestically. This no doubt reflects the less pronounced export orientation of small firms and preference for soliciting credit, denominated in pesos, in the domestic market. Continued Reliance on Suppliers Credit and Internal Funds 2.18 With domestic credit depressed and access to international credit markets still primanly limited to large exporters, most Mexican companies have relied on suppliers credit and internally generated funds throughout the recession and subsequent recovery. In fact, approximately 40 percent of firms interviewed rely on suppliers credit as their primary source of financing. 2.19 In 1996 and 1997, an increasing number of small firms relied on suppliers credit and internal funds for financing. Dunng the same period, however, large firms relied less on these sources of financing as they increased demand for international and, to a lesser extent, domestic credit- Small firms may rely on suppliers credit and internally generated funds because they have less access to credit. This is particularly true for small firms operating internationally, as these firms are less likely (at least perhaps until recently) to obtain international credits and rely more heavily than large firms on international suppliers credit. 2.20 Suppliers credit accounts for a smaller portion of the liabilities of small firms than it does for large firms, as shown in Fig. 2.12. Large firms, with their higher inventory turnover and greater bargaining power, can extend the duration of payables with less effort. Since 1992, Fig. 2.12: Mexico: Supplier's credit as % of total liabilities by size % 1991-1996 (Bolsa data) 25 20 15 10- 5 1991 1992 1993 1994 1995 1996 Year 1 Large * Medium SSmall however, the share of suppliers credit in the capital structure of small firms has increased as liabilities peaked in 1993 and reliance on suppliers credit began to grow. 15 2 Source for Fig 2 12. calculations based on data from Bolsa Mexicana de Valores 2.21 Internally generated funds (retentions or retained earnings) are defined as accumulated new income less dividends paid to shareholders. In industrial countries, especially the U.K. and the U.S., retentions are the dominant source of enterprise finance (Mayer 1991). In these countries, as trade credits have grown in importance, securities markets have declined as a source of enterprise financing over the post-war period. Equity markets have become more a venue for corporate acquisition and less a mechanism for financing industry, as the use of leverage in corporate acquisitions and share repurchase programs has grown substantially. This is reflected in part in the decline in equity market contributions to firm capital for the period shown in Table 2.3. Table 2.3: Financing of asset growth in developed countries 1970-1985 (percent, median values)' Country Total Debt Equity Internal Canada 24 0 76 France 39 0 61 Germany 11 18 71 Italy 30 18 52 Japan 52 -10 58 U.K. 7 -9 102 U.S. 36 -22 86 Source OECD Financial Statistics 2.22 At the same time, retained earnings, used increasingly among developed country companies to fund investment, has grown over the years in these countnes, reflecting the economic growth and stability they enjoyed in the period shown, and in the post-war period in general. In developing economies, however, firms have typically expenenced more frequent bouts of economic instability, particularly inflation, which has tended to erode net worth. They require funds for growth but have had less opportunity to build up retentions. As a result, they have higher retentions ratios (i.e., they pay less out in dividends, needing the cash themselves) and may require higher levels of outside financing. 2.23 In Mexico, firms' reliance on retentions and suppliers credit has been extensive, given the insufficiency of financing sources. Small companies and non-exporters, with limited outside financing options, typically have had higher retention ratios than large companies, for the reasons indicated above. (There was, however, a dramatic increase in retention ratios for medium-size and large companies in 1995, and high retention ratios continued into 1996. This reflected the need to conserve cash in order to service dollar-denominated debt with devalued pesos.) 11 Table 2 3 shows median values (in percent) of net asset growth financing by inflows on various liability- and equity- side components. The four values may not sum up to 100 percent, as median values are used. Median values are more robust to outliers of the distribution than averages. 16 Equity Issues Increase while Domestic Credit Declines 2.24 The more extensive use of outside equity (i.e., new equity investment, as opposed to retained earnings) by developing country companies compared to their counterparts in developed economies were confirmed, at least with respect to large companies, by Singh (1995). Singh examined the financing patterns of 100 top corporations in 10 emerging markets m the 1990s. Among his findings were that top corporations in developing countries rely more on outside funds -- particularly equity -- than do their counterparts in industrial countries, where equity issues are more often used to acquire corporations than to raise capital. 2.25 This difference is more pronounced in Mexico's case, where large listed companies tend to rely more extensively on equity financing than their counterparts in other developing economies. This is in large part the result of the issuance of equity in international secunties markets by large companies (in the form of American depository receipts, or ADRs).12 Mexican companies have benefited from their extensive business ties with the U.S. by becoming leaders among foreign companies in raising capital in U.S. securities markets. 2.26 The rise of foreign markets as a source of equity capital for Mexican companies in large part reflects the inability of the Mexican stock market to provide the large volume of new equity capital demand by Mexico's largest companies in the 1990s. This has begun to change, as the increase since 1996 in new equity issues on Mexico's stock exchange -- both the result of a sale of a portion of each ADR issue in Mexico and the offering of new issues by small companies on the rapidly growing small-capitalization board of the Mexican stock exchange -- has contributed to equity's increased role in the average capitalization of all listed firms. As a result of these developments, outside equity as a portion of total liabilities and net worth, which had dropped to a low of 45 percent in 1994, had recovered to 64 percent by the end of 1996. 2.27 The viability of the Mexican stock market as an alternative to bank credit for Mexican enterprises is underscored by the comparison of stock market capitalization with outstanding credit through out the 1990s as set forth in real terms in Fig. 2.13. Market growth outpaced total credit to the private sector throughout the pre-crisis period from the early 1990s through a peak in mid-1994.13 More significantly, following a drop of more than 25 percent in market capitalization between the final quarter of 1994 and the first quarter of 1995, market capitalization has risen fairly consistently ever since. This compares markedly to the continuous decline in commercial bank credit since the start of the recession. 12 As discussed more fully in Chapter 6, ADR issues compnse more than one-third of the capitalization of all listed Mexican equities. 13 It should not come as a surprise that the Mexican stock exchange peaked approximately one-half year before the start of recession, as it has been shown in the U S. that market peaks often precede the start of a recession by two quarters 17 Fig. 2.13: Outstanding credit and stock market capitalization in real terms (1990 CPI=100) 450 400n I 350 aU 300 -A- 30 &___ 1 1Stock C 250 market 200 - capitalization - Credit to the 150 -- economy 100 50 Claims on private Period Source. IFS data Financing Trends and Enterprise Investment Levels 2.28 Changes in investment levels naturally reflect the extent of economic contraction and expansion. Fig. 2.14 shows the change in real investment-the percentage of firms that increased their real investment minus the percentage that decreased it relative to the previous semester. Investment peaked in the second half of 1994, fell sharply in the first half of 1995, and started to rise again in 1996, especially for large firms. In addition, many firms shifted from investment in new assets to replacement of existing fixed assets, as the assets purchased earlier -- much of them durng the easy credit days of the early 1990s--now require replacement. 18 Fig. 2.14 Patterns of change in real investment Difference in % shares of respondents who indicated increases and decreases in investment % pts ibbrealinveaond to the preceding period 50. 40- 30- 20- 0 -104 -20-P 1/93 11/93 1/94 11/94 1/95 11/95 1/96 11/96 1/97 Year E3 Small real investment N Medium real investment 0 Large real investmedt Source Bank of Mexico business-environment survey. 2.29 Financing investment when financing options are limited means that many companies utilize whatever funds might be obtainable, no matter how appropriate to the task. Some firms, for instance, particularly small ones, appear to be using short-term bank credit to fund investment. This is based on the observation that both increased investment and increased short- term bank debt seem to occur at the same time each year. Small firms typically obtain short-term credit from domestic banks. In the absence of long-term debt, short-term financing intended to augment working capital is used to fund long-term investment. This costly and volatile way to finance investment can result in prolong crisis in the small and medium sector during economic downturns. This situation may change in the intermediate term, however, as an increasing number of firms are accessing long-term debt abroad. 2.30 Thus during the recovery, increased demand for credit has been associated with increases in fixed investment. Large companies reported increased demand for foreign credit and increased real investment by late 1995. Small companies increased demand for domestic credit and increased real investment later on, starting in 1996, though not being fully satisfied until 1997. Enterprise data from the recovery penod show a positive correlation between fixed investment, installed capacity and, ultimately, capacity utilization. Toward Greater Financing Choices for Enterprises 2.31 The Mexican economy is poised for significant growth as it integrates with the global economy. Liberal trade policies and agreements, such as NAFTA, should enable exporters to sell an increasing portion of their production abroad, and more firms will enter the export arena. Exporters will continue to solicit medium- and long-term non-peso debt and equity capital abroad if they cannot get it at comparable cost at home. 19 2.32 Exports may become less concentrated among large firms as trade opportunities grow and as more firms gain access to foreign financing. During the peso crisis international financing may have been the exclusive domain of large exporters, but the increasing orientation of small and medium firms to export markets means many more firms will have access to long-term dollar debt. In an effort to gain competitiveness in the face of competition from foreign banks for its traditional SME market, domestic banks may eventually meet the needs of these firms by supplying peso and non-peso debt. 2.33 At the same time, a broader range of Mexican enterprises can be expected to issue equity both abroad and at home. Mexican equities will of course benefit as the Mexican economy continues to expand, but long-term growth and sustainability of both credit and equity markets will depend in large part on essential changes in the financial sector infrastructure, the legal and regulatory environment that provides the underpinning for investor participation and protection of participant rights, as will be seen in subsequent chapters Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure 3. INTER-COMPANY FINANCING AND THE GRUPOS INDUSTRIALES 3.1 The difficulties enterprises have faced in raising capital as a result of an underdeveloped financial sector, and the resulting search for capital abroad by many Mexican firms, was documented in the previous chapter. In the absence of financial market alternatives, the financing benefits companies receive by joining large industrial groups -- many of which are counted among the large exporting corporations with access to international debt and equity financing -- in part explains the attraction of their affiliation Background 3.2 This chapter explores the mechanisms used by the largest enterprises to facilitate the provision of capital to their smaller affiliates. We first look at the financial structures of the grupos, which vary based on the extent of their (de-)centralization. The range of internal financing mechanisms are explored prior to looking at how grupos help outside firms -- small indirect exporters and small customers -- acquire financing in ways they could not on their own. Finally, we attempt to weigh the benefits of group membership against their potential for suboptimal allocation of resources. 3.3 Throughout the 1970s and most of the 1980s, fiscal and commercial policy reflected Mexico's bias in favor of ologopolistic modern industries. Mexico's cross-shareholding industrial conglomerates are the products of these policies -- today among the largest enterprises in the country. Their growth was facilitated by a combination of protection, subsidized credit, paratstatal pricing policies and privatization, which enabled acquisitions in specific sectors. They account for a large proportion of exports, and during and following the 1994 crisis have been an important source of intra-group and affiliate financing. Unlike most Mexican firms they have also been able to tap international credit and equity markets. 3.4 Drawing upon interviews and fieldwork in Mexico City and Monterrey, this chapter analyzes the financing arrangements established within the large Mexican industrial-economic groups, or grupos, as well as between grupos and other firms in the Mexican economy. This section suggests that several Mexican grupos have actually created "substitute" capital and credit markets where such markets may not have otherwise been accessible to either grupo- or non grupo-affiliated companies. By mediating between their member companies or between their subsidiaries and their major suppliers and customers, grupo holding companies may have significantly shielded member companies or linked companies from the worst financial effects of the 1994-1996 cnsis, while in many cases providing capital to weak links that perhaps would not otherwise have access to financing. 3.5 We find that several holding companies successfully lowered the costs of capital for their affiliated and trade-related firms through the use of unique monitoring mechanisms to support "relational" contracts between companies where arms-length contracts may not have been feasible. Among the mechanisms used, conglomerates (1) used the grupo name to enter new businesses; (u) absorbed a portion of investment and credit risk; (iii) built up internal credit markets through the use of cross-subsidiary lending or holding-to-subsidiary loans; or (iv) 22 internalized some of the coordination problems--especially those present in industries characterized by economies of scale, or by some degree of non-tradability of technologies or goods--between these enterprises by forcing the consolidation of large numbers of small suppliers or customers, or by integrating forwards or backwards. Organizational and Financial Structures 3.6 Although the thirteen firms interviewed for this section exhibited different corporate forms, they can be usefully categorized along two dimensions: (i) the degree of vertical integration in core businesses; and (ii) the level of centralization in cash and balance-sheet management across the industrial group. Vertical Integration 3.7 By definition, "grupos" are industrial conglomerates consisting of several subsidiaries engaged in diversified business activities, each of which is partially or wholly owned by an administrative or managerial holding company. Subsidiaries may exist directly under the parent, or separated by "layers." Some may be organized into administrative "divisions" based on the main activities undertaken or based on historical affiliation in the case of grupos that have grown through acquisition. Further complicating matters are the presence of "sub-holdmg" units under the main parent, especially in cases of the larger grupos (CARSO, Alfa). Under the umbrella of the holding company, the different core businesses may themselves exhibit greater or fewer degrees of vertical integration. On this basis we can categorize these divisions as vertically integrated, unintegrated, or as hybrids.14 In general, we find that grupos manufacturing those products with greater brand-name recognition have typically wanted to protect that reputational advantage by expanding further downstream or upstream. An illustrative example is the case of CYDSA, a specialized chemicals and synthetic fibers producer, which has integrated its chemicals, fibers and textiles, and packaging materials divisions as far forward as possible. Cash and Balance-Sheet Management 3.8 A second category refers to the extent to which the control of grupo capital is centralized or decentralized, that is, the extent to which working capital and investment are financed with allocated resources from the holding or by resources acquired independently by the subsidiary. In principle, the distinction is a simple one: where financial control is primarily at the holding level, it is the holding company that allocates financial resources to the subsidiaries, which are typically forbidden from taking on loans or from issuing equity. Under centralized cash-flow management, working capital is financed from above, while profits are "upstreamed" to the holding company.'5 Alternatively, funding needs can be financed with credit to the individual subsidiaries, with or without the guarantees of the parent, or by subsidiaries controlling their own capital structures. This structure is common in grupos where subsidiaries are not wholly owned. 14 By "hybrid" in this sense we refer to industnal groups characterized by both integrated and non integrated operations. At least one grupo indicated that bank financing always takes place at the holding company level as a way to insulate itself from any lender claims on assets, which are all held at the subsidiary level. This approach would also insulate the company from lender attempts to prevent upstreaming of profits 23 3.9 In practice, there are several arrangements which blur the distinction between centralized and decentralized financial management. One occurs when the holding behaves as a "quasi- bank" and extends loans to subsidianes. Another is the arrangement whereby certain subsidiaries are allowed to borrow independently, while others are restricted from taking on debt. One test regarding the degree of centralization is whether subsidiaries are allowed, on their own, to borrow from and lend to each other or whether such allocation are administratively made at the holding (or sub-holding) level. 3 10 We classify the twelve grupos according to these critenas. Although the most common financial arrangement appears to involve some degree of financial centralization, levels of vertical integration vary widely across firms, as do debt-to-equity ratios, profit margins, sales volumes, and total assets. Equity Financing and Dilution 3.11 When grupos determine that an equity offering is the optimal form of financing, having compared the costs of financing alternatives, they tend to sell shares in the holding company itself, not in the equity of particular subsidiaries. Many grupos have found themselves with publicly traded subsidiary shares following acquisitions. Most, such as for example DESC, have discovered that the market liquidity of subsidiary shares was low, lower than the implied value of those units if calculated based on the market capitalization of the holding company. While the historic low liquidity of small capitalization stocks in Mexico appears to have discouraged the use of the Mexican stock market as a means of subsidiary financing, there are other factors to consider as well, such as dilution of control over subsidiary; effects of having new shareholders on intercompany financing, upstreammg of profits and other transfers; and the high the costs of listing subsidiaries (relative to total offering proceeds). 3.12 Loss of control is also a consideration for many grupos when considering issuance of holding shares as a financing alternative, in particular when a family or individual still owns the majority of shares ' CARSO, for example, indicated a preference to de-list subsidiaries, and in this case the primary reason given was to increase control. Fear of diminution of control appears to be less of a consideration in those grupos utilizing highly sophisticated cash management techniques; in these cases share issuance is determined largely on a comparative cost of capital basis. Internal Financial Flows and "Surrogate" Financial Markets 3.13 One of the effects of intra-conglomerate financing, or supplier-to-purchaser financing involving conglomerates, is that conglomerates can use their internally-generated capital to provide funds to companies and enterprises that would normally be too small or too risky to receive funds from credit or capital markets on their own. In this category are both "affiliated" companies--companies that are members of grupos--and subsidiaries which could not stand on their own as complete companies. Although in certain cases, share offerings have been made to provide liquidity to controlling shareholders, this rarely results in loss of enterprise control. 24 Intra-grupo finance 3.14 As indicated in this study, the contraction in domestic credit following the 1995 financial crisis raised the costs of borrowing for the real sector. At the same time, as will be shown in Section V, public share offerings and venture capital financings were primarily the province of large corporations, and bank credits were nearly non-existent. In sum, the singular benefit that subsidiaries received 'from grupo membership was access to capital at reasonable cost. In this sense, certain financial arrangements between holding companies and affiliated companies and subsidiaries provided the concrete benefit of lowering risk to lenders and investors. 3.15 Firm interviews revealed that holding companies might lower overall credit risk by absorbing a portion of the total risk that a lender would otherwise bear, or by encouraging nsk sharing between subsidiaries." In highly centralized grupos, the holding company simply takes on bank debt or (less commonly) issues paper, then allocates funds to subsidianes according to the imperatives of their investment plans and other capital requirements, thereby using the advantage of size to borrow or to raise capital for the member companies; subsidiaries often do not even maintain their own cash accounts. In less centralized grupos, holding companies might actually lend to member companies that are otherwise too small to obtain capital from Mexican financial intermediaries, creating a regulated internal "market" for loans. In decentralized grupos, finally, where subsidiaries were free to raise capital on their own, the presence of holding-level guarantees--explicit or implicit--removes some of the risk that creditors would bear in lending to smaller and medium companies. Financial autonomy and subordinated debt 3.16 Of the corporations surveyed, eight out of thirteen -- Elektra, CARSO, Hermes, CEMEX, IMSA, Pulsar, Vitro, and Alfa -- allow subsidiaries to take on debt independently. In all of these cases, restrictions on upstreaming profits to the holding company were sometimes put in place, but not uniformly. Although subsidiaries in CYDSA cannot take on debt on their own, debts acquired by the holding may be "farmed" out to the subsidiary, and thus placed on the books of the subsidiaries by accounting flat. Of the eight listed above, holding companies of the three largest grupos--CARSO, IMSA, and Alfa--do not offer parent guarantees for subsidiary loans; these represent the most financially decentralized companies. Our interviewees cited a number of reasons why this would be the case. Mainly, these grupos were formed primarily by acquisition of unrelated companies over long periods of time. As such, most of the subsidiaries already had long-established relationships with banking and financial institutions in Mexico. Additionally, subsidiaries of CARSO, IMSA, and Alfa were among the companies with the greatest degree of international (export) exposure, and most were capable of foreign borrowing. This is not true in all cases. Pulsar, for instance, has most of its operating subsidianes incorporated in the U.S These companies raise capital in the U.S. more cheaply than their Mexican-based holding companies can. Note that decentralized grupos which allow borrowing and lending among subsidianes may also create "internal" credit markets sunilar to the case where the holding company acts as a "quasi-lender"; cross- subsidiary lending, as with vertical (holding-to-subsidiary) lending, spreads nsk by allowing cash-starved companies to benefit from relationships with wealthier companies This is not only true literally, but indirectly, as strong subsidiaries support the holding subsidiaries credit rating (or bank rate), and weak subsidiaries benefit as holding allocates funds. In addition, upstreamed profits can be reallocated to subsidiaries in need, usually as debt. 25 3.17 There is some evidence that strong subsidiaries finance others. In some cases only a select subsidiary or group of subsidianes within a grupo are large exporters capable of raising funds abroad. These funds (or a portion thereof) can then be used to finance subsidiaries that face difficulty in financing themselves. For example, DESC's autoparts manufacturing subsidiary raises capital abroad, which is then used by its domestic real estate development subsidiary. This was an important (and possible the only) source of capital for this subsidiary during the financial crisis. Finally, having to subordinate holding-guaranteed debt of subsidiaries as a condition of subsidiaries qbtainng outside debts is effectively a holding company guarantee as well (as it agrees to allow the new debt ahead of 1 in the event of bankruptcy. 3.18 Holding companies in Elektra, Hermes, CEMEX, Pulsar, and Vitro, by contrast, all routinely provide guarantees in varying amounts to the financiers of their subsidiaries. In certain cases, guarantees may also be provided by financially strong subsidiaries, in which case banks would not restrict funds flow between these subsidiaries. Most grupo financial officers suggested that parent or affiliated guarantees should ultimately be eliminated, but in the medium term their subsidiaries could not raise capital without such guarantees. Where subsidiaries were able to borrow at an average cost of capital--such as in those cases where subsidiaries conducted all or most of their commercial activities abroad--guarantees were not employed. Such is the case with CEMEX, for example, under which parent guarantees were used for Mexican companies in corporations in which subsidiaries are expressly forbidden from acquiring debt (CIFRA, Bimbo, Gruma, CYDSA) are the most highly centralized in our sample; organizationally, these firms resemble the multi-divisional ("M-form") firm more than they do conglomerates of autonomous companies. Supplier and Customer Relations 3.19 Mexican grupos have employed one of three strategies to deal with the problem of coordination failures and other externalities in upstream or downstream markets: These are: (i) explicit credit programs; (ii) consolidation programs; and (iii) backward or forward integration. Financing suppliers and purchasers 3.20 Companies benefit from the use of suppliers credit primarily when they receive payments from customers for goods and services before they must make their own payments to suppliers for production inputs. These arrangements may take several forms. Conglomerates that established credit or other sorts of financing programs for smaller suppliers or customers, similarly, did so as a way of lowering the risks that financiers of these "linked" firms faced. In the past three years, the major Mexican development banks have reduced the size of their portfolios. In several instances, the lack of finance available to linked sectors threatened to destabilize the normal product chain that grupos relied upon. In the case of the agro-business conglomerates, CIFRA, Bimbo, DESC, and Gruma, (whose best-known subsidiary is Maseca), the lack of financing available to small corn, potato, and wheat farmers might have led to unavoidable hold-ups had these corporations not provided some form of assistance. Micro and small suppliers, for their part, often face considerable difficulty in waiting to receive customer payments on standard terms. 3.21 The large, agro-business grupos are instrumental in assuring that their small suppliers have access to working capital financing. DESC, for instance, simply provides a short-term loan 26 guarantee on behalf of farmers in exchange for multi-year contracts to take all farm production. DESC thus obligates itself to the bank but takes the farmers' land as collateral. This reduces DESC's risk in the event the farmer does not repay but leaves DESC open to the inadequacies of Mexico's collateral laws (as discussed later), possible questions regarding the farmer's land title, and the potential for unfavorable populist reaction should land repossession be attempted. 3.22 CIFRA utilizes a special arrangement in which NAFIN in effect acts as a factor to the company's small suppliers by filling the float to which small suppliers would normally be subject. Under the terms of this arrangement, NAFIN pays small suppliers for all of their merchandise at a slightly discounted rate before the penod (usually 45 days) by which they would they would normally be paid by CIFRA. CIFRA then, in turn, pays NAFIN the discounted amount, plus interest, after the 45-day period. Gruma, on the other hand, participates in NAFIN's "Fidecomiso AAA" program, by which NAFIN provides credit to a triple-A-rated company, in this case Gruma, which in turn effectively serves as a second-tier financial intermediary, on lending these funds to its small suppliers. Gruma also absorbs a portion of the loan risk borne by commercial banks that lend to farmers. In addition to committing to purchasing all of a farmer's crop, Gruma also guarantees 10 percent of his loan.19 Gruma also provides small customers with a simple credit procedure: It does not require payment until a subsequent order is placed. 3.23 Seven grupos in our sample provided some form of limited credit to their major customers, typically a float between delivery of goods and payment. Companies such as CIFRA and CARSO, which have medium- to high-end retail sales operations, are able to finance suppliers credit through the use of credit card sales, since they receive payments from their bank on credit card sales, at a small discount, within 24 hours, while the bank collects on these sales within 30 days. Consolidation 3.24 In addition to providing direct or intermediated credit, Bimbo and Gruma have also implemented a form of consolidation among its suppliers. Both companies were, to a certain extent, limited in their capacity to exploit economies of scale in agnculture, mainly due to the ejidatario system that promoted small-holding farms--five hectares per farmer, on average. Both companies, therefore, encouraged the formation of growers' associations of 200 to 300 farmers through a variety of incentives, including agreements with insurance companies to offer greater protection for the harvest of association members, and perhaps the unstated intention of both companies to purchase only from the associations as a whole. These consolidations have also enabled increased consistency and quality control of inputs. It has also enabled increased access to bank financing by farmers who could now borrow against firm contracts from these companies. Both companies have cited noticeable improvements in crop yields as testimony to the success of these consolidations. Integration 3.25 The last method by which grupos internalized externalities in linked markets is through integration. Some form of backward or forward integration has been employed by eight firms in The other 90 percent of these loans is guaranteed by Bank of Mexico. This arrangement grew out of the so-called Barc6n movement in 1994, during which growers refused to repay banks that had lent to them, demanding instead some form of loan restructuring. 27 our sample. Note that of these eight firms, three (IMSA, Alfa, and CYDSA) have purchased a large portion of their inputs from the state-owned petroleum monopoly, PEMEX, limiting their capacity to integrate upstream. All of these companies have integrated downstream into packaging, distribution networks and recycling. CARSO, CEMEX, IMSA, and Alfa have also integrated into minerals mining (in the case of CARSO, CEMEX, and Alfa) and smelting (CARSO, IMSA). 3.26 In the cases where grupos have relied on brand-name recognition for a large portion of their sales, finally, holding companies may have become concerned that advertising or other brand-specific treatments may have been inadequate among distributors or retailers. Under such circumstances, grupos attempted to integrate into distribution and retail where feasible, such as in the case of IMSA's car battery division, or to settle exclusive long-term contracts with retailers for their particular brand, as in the case of CYDSA's "San Marcos" clothing line. Issues Specific to Mexico 3.27 Mexican grupos are, for the most part, companies with considerable sales abroad They must, however, deal with specific issues as a result of being Mexican-based. Country Risk 3 28 One issue facing Mexican grupos is the cost of perceived country risk. CEMEX represents an interesting case in this regard. Its Spanish-based subsidiary had been raising relatively low cost debt. CEMEX decided to use these less expensive funds to have the Spanish subsidiary purchase the company's Mexican subsidiaries, whose costs of borrowing were higher. The effect of these transactions have been to shift leverage to the international subholding from the less profitable and more highly leveraged Mexican subholding. In the process, CEMEX is able to lower its overall cost of capital by decreasing its Mexico cross-border risk premium. This risk premium is the single element which causes international conglomerates based in Mexico to have higher overall capital costs in comparison to similar companies based in developed countnes. Economic Stability 3.29 Another aspect of being Mexico-based is concern for economic stability. Fearing market volatility and the resultant increased cost of floating-rate, short-term debt, most grupos have arranged for back-up credit commitments, "just in case". Many pay commitment fees for these lines, even when unused. Some of these firms prefer to have their back-up facilities in long-term (usually dollar-based) debt instead of short-term. Even if long-term rates may be higher, they are typically more stable than short-term rates. 3.30 Thus we see from these examples yet additional reasons why Mexico's historic financial instability has increased the cost of capital of even its largest firms and has forced the financing decision-at least in the case of back-up facilities-to be based on factors other than price. Maximizing Capacity and Adding Value 3.31 Our interviews suggest that grupos, as expected, exploited their size, geographic and sectoral diversity to maximize their capacity to raise funds during the height of the financial 28 crisis. But the highly diversified grupos also may have added value by filling the void left by several institutions that were absent or ineffective m the Mexican economy. 3.32 First, in the case of product markets, where buyers and sellers suffered from a shortage of information about products, and where smaller companies may have faced much higher costs in establishing credible brands, Mexican grupos attempted to use the grupo name to enter new businesses, and spread the cost of maintaining brand names across multiple lines of business, as in the cases of CARSO, IMSA, Vitro, Alfa, and CYDSA. Such grupos, naturally, faced strong incentives not to damage their brand quality because they would consequently suffer in other businesses as well. 3.33 Second, grupos reduced the cost of capital to affiliated firms, by taking on a portion of credit risk. But grupos also reduced risk to investors. Financial officers at the companies we interviewed suggested that investors were unwilling to put money into local companies; in addition to the holding acting as a lender of last resort, holding companies may have solved certain problems in the Mexican "market for corporate control" through their internal systems of managerial appointment and removal, and through their involvement in a highly diversified group of companies, thus providing the information and safeguards that the Mexican capital market could not. 3.34 Third, some of the larger, more diversified grupos mobilized the large amounts of capital to establish internal capital and credit markets, enabling subsidiaries to borrow from each other or from the holding on terms that would otherwise have been unable to them. More importantly, these companies would also have been locked out of the market for long-term finance in particular. Holdings that allowed intra-grupo transfers of funds (either through cross- subsidization or by lending, then accomplished two things: (1) it prompted richer companies to help the poorer with their cash flows, even when the short-term outlook was uncertain (as might have been the case in some of the infant sectors); and (ii) spread risks across businesses. 3.35 Fourth, grupos established a channel for public funds to reach small-scale suppliers through NAFIN and Banxico programs. In both cases, the benefit of grupo participation was in intermediating between NAFIN and commercial banks on the one hand, and small entrepreneurs on the other, on two accounts: by guaranteeing a portion of the credit risk, and by supplying (presumably) unbiased information about the suppliers to these public institutions. 3.36 Finally, grupos provided solutions to problems of coordination between linked sectors by consolidating large numbers of small and medium suppliers, or by integrating forwards and backwards as far as was permissible. 3.37 These inter-company financing links are notable as an example of private sector initiative in response to development bank withdrawal. They also highlight a need for the development banks to facilitate the entry of private enterprise into this role. As we have seen, there are various financing mechanisms now in place in which NAFIN and other development banks to provide financing through large enterprises instead of financial institutions. These involve innovative schemes to provide receivables financing, factoring and other short-term credits to small companies. 29 Implications of Intra-Grupo Finance 3.38 It should be noted that the proliferation of grupo-based financing schemes emerged from, rather than presaged, a general financial dismtermediation in the Mexican economy. Specific kinds of intra-grupo financial activities--particularly the provision of suppliers credit and the practice of guaranteeing credits, certainly increased during the contraction of credit between 1995 and 1996, enabling companies to raise capital at a partially subsidized cost. 3.39 A central question, then, is what are the costs of intra-grupo financial arrangements? It is difficult to answer whether the degree of internal credit allocation by grupos is functionally efficient, that is, whether intra-grupo finance allocates resources to their optimal uses. The firm- level, systematic data needed to answer this question were not available for this study. But even the results from such an analysis would need to be examined with skepticism, since while it may be true that grupo holding companies may have allocated capital in inefficient ways, we would need comparable analysis of functional efficiency in the Mexican banking system to make comparisons. 3.40 From a regulatory-institutional perspective, however, conglomerate finance does create certain problems. First, a system of internal financing by diversified industrial conglomerates makes financial liabilities in an economy much more difficult to monitor (and therefore to regulate prudentially) than would a concentration of financial liabilities in the banking system. Second, intra-conglomerate financing typically shelters lossmaking enterprises (sometimes at the expense of the profitable subsidiaries) and, as a result, a single lossmaking subsidiary can worsen the financial status of the entire group. Third, the presence of large conglomerates--especially in rising-cost industrial sectors--raises the specter of high cost entry, transfer pricing, and other anti- competitive practices. Fourth, the sheer size of conglomerates often forces governments to offer implicit insurance for those financial liabilities. As demonstrated in the financial crises in East Asia of 1997-1998, this government insurance can encourage risk-taking binges among the conglomerates that benefit. 3.41 In conclusion the benefits of access to financing for small and medium-size companies affiliated with large industrial groups is clear. Questions regarding the potential for anti- competitive activities and the efficiency of resource allocation are less so; group membership may be good for its members but discriminatory to non-members that may be more efficient. Further study in this area is warranted. 3.42 From a regulatory-institutional perspective, however, conglomerate finance does create certain problems. First, a system of internal financing by diversified industrial conglomerates makes financial liabilities in an economy much more difficult to monitor (and therefore regulate prudentially) that would a concentration of financial liabilities in that banking system. Second, intra-conglomerate financing typically shelters loss-making enterprises (sometimes at the expense of the profitable subsidiaries) and, as a result, a single loss-making subsidiary can worsen the financial status of the entire group. Third, the presence of large conglomerates--especially in rising-cost industrial sectors--raises the specter of high costs to entry, transfer pricing, and other anti-competitive practices. Fourth, the sheer size of conglomerates often forces governments to offer implicit insurance for those financial liabilities. As demonstrated in the financial crises in East Asia of 1997-1998, this government insurance can encourage nsk-taking binges among the conglomerates that benefit. 30 3.43 In conclusion, the benefits of access to financing for small and medium-size companies affiliated with large industrial groups is clear. Questions regarding the potential for anticompetitive activity and the efficiency of resource allocation are less so; group membership may be good for its members but discriminatory to non-members that may be more efficient. Further study in this area is warranted. Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure 4. SOURCES OF ENTERPRISE CREDIT 4.1 The previous chapters have focused largely on enterprise demand for credit and the activities of large companies in accessing capital and facilitating its delivery to often smaller companies. We now turn our attention to sources of enterprise credit, which, in recent years have been shaped by a sharp decline in real domestic commercial bank credit and increasing dollarization of enterprise debt. The decline in domestic banking has had considerable impact on other domestic sources of secured credit, including leasing and factoring, and on the operations of development banks and non-bank financial institutions as well. 4.2 While progress has been made in stabilizing the banking system, the quality of bank earnings remain poor, the liquidity of the weakest banks remains insufficient, and bank capital requires improvements in quality and quantity. Furthermore, the nsks of granting credit continue to be exacerbated by the legal and enforcement difficulties banks and other creditors face in recouping assets. These include: * complicated and expensive bankruptcy procedures, a critical obstacle in the resolution of non-performing bank loans; * weak laws on secured transactions, which require reform to permit floating liens on movable property and changes in the process of recording of ownership title in asset registries; * restrictive rules for loan documentation, which make enforcement nearly impossible; and * an ineffective judicial system, shackled by tremendous backlog of processes and a lack of expertise and resources (human and infrastructure), makes the enforcement of creditors' rights a cumbersome, time-consuming and expensive affair. 4.3 Findings presented in the 1998 CEM indicate that countries affording high levels of protection of creditor rights have significantly better developed banking systems. Legal and regulatory reform is essential in Mexico if commercial banks and other providers of credit are to have the capacity to provide a sufficient volume and variety of financing to satisfy the demands of a broad range of Mexican firms. Profile of Mexico's Credit Markets 4.4 The chapter begins by focusing on the factors that have influenced the supply of credit available to Mexican enterprises since the 1994 financial crisis. (Legal and judicial reforms are discussed in detail in Chapter 7.) The markets for credit in Mexico display several defining trends, discussed below. Real Domestic Commercial Bank Credit Down 31 4.5 Since late 1994, domestic commercial bank credit to the private sector has dropped 27.6 percent in real terms. On the supply side, credit volume has been affected by the large losses suffered by banks as a result of the 1994 crisis, by a large drop in bank deposits, and by banks' reluctance to lend without high levels of collateral coverage. The demand for domestic credit was constrained by the substitution of international credit and the slow recovery of non-exporters. International Credit Markets Increase Importance 4.6 Large exporters, the first group of enterprises to recover from the peso crisis, have increasingly sought credit from international sources. Most other Mexican companies did not show signs of recovery until 1996-a year later than large exporters. Only in 1997 did smaller companies begin making inroads into international credit markets. Dollar financing offers Mexican companies reasonably priced medium-term credit that has been unavailable on the domestic market. With the variety of hedging mechanisms (which eliminate the effects of currency fluctuations on debt service capability) available to Mexican firms today, even non- exporters can benefit from raising three- to seven-year dollar-denominated money to fund investment. Other Secured Financing Down 4 7 As with commercial banks, leasing and factoring companies experienced fast growth during the early 1990s, the result of financial sector deregulation, economic liberalization and expectations of rapid economic growth. But rapid growth in marginal leases prior to 1995 occurred in the absence of adequate controls, both financial and regulatory. Combined with sharp cutbacks in bank credit to these institutions during and after the cnsis, these shortcomings caused severe contractions in the operations of leasing and factoring companies. Poor Performance of Small Non-Bank Financial Institutions 4.8 Until 1994, non-bank financial institutions, particularly credit unions, were the main mechanism used by development banks to channel funds to micro- and small enterprises. Since then, however, credit unions have suffered a 60-percent real decline in loan portfolios, the result of sizable nonperforming loans. Savings and loan societies, whose loan portfolios are based on peso-denominated deposits, have fared somewhat better. Small but Growing Market for Corporate Debt Securities 4.9 Despite rapid growth in 1997 and their potential as a source of financing for Mexican firms, traded markets for banking and industrial debt securities represent a small fraction of available credit. Most of the market consists of government securities, although banks have recently used the market to restructure borrowings and fund lending operations. 32 Box 4.1 Comparison of Scandinavian and Mexican Banking Crises The Scandinavian banking crisis which occurred in the late 1980s / early 1990s provides an interesting point of comparison with the Mexican banking crisis which began in 1994 Despite some significant differences in the nature of the crises, the more pervasive impact of the Mexican cnsis was largely due to the greater fragility of the Mexican banking system vis a vis those of Scandinavia. In this regard, two key issues stand out as setting the Scandinavian countnes apart from Mexico: the existence in the former of adequate legal means for resolving non- performing loan problems, and their clear accounting and transparency rules which make the banking sector transparent to depositors and borrowers alike The Scandinavian countries, like Mexico, had undergone a significant change in the banking regime in the years leading up to their crisis. All of the Scandinavian countries except Denmark undertook rapid deregulation in the mid-1980s that raised lending ceilings and encouraged borrowing through fiscal measures. As with the privatization of the banking sector in Mexico, this led to increased competition in the banking sector, characterized by a heightened focus among banks on increasing market share. In both countries, much of the increased lending which resulted went towards financing real estate In Scandinavia, banks lent heavily for commercial property development, spurred on by fiscal policies that sent property prices soaring. In Mexico, among other areas, banks rapidly increased mortgage financing. Not only was housing finance an untapped and potentially lucrative market, but it was also a convenient way to improve the image of the banks and the government among the population Under the new banking regimes, bankers in both Mexico and Scandinavia were unable to adapt quickly their lending practices quickly to the new requirements of an open and competitive banking sector. Banks were unable to assess credit risk appropriately in the more volatile economic situation and were not skilled at pricing their products to cover the real risks being undertaken. In Mexico, some of the new owners had historically been involved in financial brokerage activities. This contributed to their more risky and speculative approach to lending In Scandinavia, government lending controls had made risk-based pricing unnecessary, a situation which was not remedied by the banks after deregulation. In both regions, the herd mentality also contributed to over-concentration of bank loans in a few sectors, increasing the overall nskiness of banks. In the years that followed the change in banking regimes, both Scandinavia and Mexico paid insufficient attention to the regulatory and supervisory requirements of the new environment In Scandinavia, this was a question of the supervisory authorities not adapting their procedures to the new regime, while in Mexico the problem was a delay in the actual establishment of the appropriate regulatory and enforcement capabilities, which provided opportunities for insider dealing to further compromise the banking system Contributing to this disparity was Mexico's lax accounting and transparency standards, which obfuscated the composition of bank loan portfolios. their loan loss records and their solvency situation The events that triggered the crises were themselves different in Scandinavia and Mexico In Mexico, the cause was primarily endogenous - the devaluation of the peso, which itself was partially caused by price pressures from credit expansion. In Scandinavia, the triggers were exogenous. Finnish banks suffered from the collapse of their Soviet markets, Norwegian banks suffered from the collapse of oil prices, and Swedish banks suffered when the elimination of foreign exchange controls made foreign real estate investment more attractive than domestic investment The results were similar in that in both cases the new economic situation led to a deterioration in bank assets and an increase in non-performing loans The impact that such non-performing loan portfolios can have on a country's banking system depends largely on its legal infrastructure, in particular the legal underpinnings for protecting the rights of poperty owners and collateral holders, for declaring bankruptcy, for the private restructunng of debts In Scandinavia, where non- performing assets could be relatively easily liquidated by the banks due to the efficiency of its bankruptcy laws and its judicial enforcement capacity, the extent of losses resulting from repayment problems was relatively minimized In contrast, in Mexico the inefficiency of bankruptcy laws and the lack of clarity regarding the ownership rights of creditors hindered the speedy resolution of non-performing portfolios If, as in the case of Mexico, widespread arrears and defaults are tolerated with only minor repercussions to the borrowers, the potential for moral hazard among borrowers is increased and a further deterioration of bank portfolios can be expected The result is a much more severe and pervasive crisis than would otherwise occur Although certain individuals may gain from this form of arbitrary forbearance, society as a whole will suffer if the rights of creditors and borrowers alike cannot be fairly and cffectively enforced 33 A. Domestic and International Commercial Banking 4.10 Between the onset of the peso crisis and March 1997, commercial bank credit to the private sector dropped 27.6 percent in real terms, as can be seen in Table 4.1. At the same time, bank deposits, a significant source of bank funds, dropped 15.0 percent between late 1994 and the end of 1996, and although they increased 3.5 percent (in real terms) in the first half of 1997, they were still about 4.0 percent lower than in 1994. In addition, bank deposits are highly concentrated, with one percent of accounts representing 51 percent of deposits. Table 4.1 Banking system credit and deposits (billions of MP'S--real terms) Dec 94 Dec 95 Mar 96 Dec 96 Mar 97 Outstanding credit to private sector 543.5 452.1 430.6 405.4 393 5 Total deposits 452.4 380.1 382.4 384 7 399.9 Note. Nominal figures have been deflated by "Indice Nacional de Precios al Consumidor" (base 1994=100) Source Indicadores Economicos, Banco de Mexico, Sept 1997 4.11 High inflation rates resulting from the peso devaluation pushed nominal interest rates as high as 65 percent during 1995, as indicated in Fig. 4.1. Real interest rates by and large have not risen significantly from those experienced during the pre-cnsis period of credit expansion. The absence of a revival in bank credit flows serves to highlight the demand- and supply-side factors -- the low enterprise demand for credit and the substitution of international credit, a concern about the creditworthiness of borrowers and a general nsk aversion among banks to increased lending -- which continue to inhibit domestic credit growth. Fig. 4.1: Interest rates and real outstanding credit (1990 CPI=100) 440 70 390 60 340 50 240 -/' r 30 C ~~ Nominal T-bill C" El n (CETES) rate tj I2 M Real T-bill (CETES)i 140 n fl, i I rate -A- Claims on private sector -* Creditleothe 40 -10 economy Cy~ 0 0 a a, a a a period Source. Indicadores Economicos, Banco de Mexico, Sept 1997 34 Potential for Credit Recovery 4.12 There are, nevertheless, signs that lending may be poised for recovery. For the first time since 1994, some of the largest banks reported small increases (ranging from 0.5 to 1.5 percent) in lending in 1997. Moreover, excess demand for credit-the difference between what companies solicit and what banks grant--declined considerably for small companies. A much larger portion of small companies received bank loans when requested than had in the past two years. 4.13 A particular disincentive to the growth of deposits is a 1.7 percent tax on savers' fixed- income deposits. As this is effectively a tax on the interest income itself, it has the effect of causing banks either to raise interest rates on these deposits to keep them competitive, or risk a lower level of such deposits if they do not. Consideration should be given to eliminating this rule. Decline in Development Bank Credit 4.14 The decline and limited recovery of domestic commercial banks are mirrored in the activities of Mexico's development banks, which between December 1994 and March 1997 accounted for less than eight percent of the loans granted by the banking system to the private sector, as set forth in Table 4.2. More than 80 percent of credit granted to the private sector through development banks is provided by the three largest: NAFIN, BANCOMEXT, and BANOBRAS. NAFIN and BANCOMEXT finance mostly industrial activities; BANOBRAS focuses on housing and infrastructure. Table 4.2: Outstanding Credit to Private Sector (Millions of US$) Dec 94 percent Dec 95 percent Dec 96 percent Mar 97 percent Banking 117,811 100.0 100,026 100.0 111,000 100.0 112,861 100.0 system Commercial 108,979 92.5 92,235 92.2 102,966 92.8 104,564 92.6 banks Development 8,832 7.5 7,791 7.8 8,034 7 2 8,297 7.4 banks Note Peso denominated data converted into US dollars using end-of- the period exchange rate Source- Indicadores Econ6micos, Banco de Mexico, Aug 97 4.15 Development banks lend to the private sector either directly (first-tier operations) or indirectly (second-tier operations) through commercial banks or other financial institutions To a lesser extent, they also lend through non-bank financial institutions and, in a new development, through large enterprises. First-tier lenders always bear the risk of lending, and in recent years commercial banks have been reluctant to lend to enterprises despite the availability of funds through the development banks' rediscount facilities. Although development banks abolished interest rate ceilings on second-tier loans in 1996, allowing commercial banks to charge market 35 rates for their rediscounted loans, credit flows from development banks to the private sector have continued to fall. Despite the decline in first-tier lending, development banks should in general refrain from direct lending to enterprises so as not to "crowd out" private sector commercial banking institutions. Current and Prospective Bank Credit Operations 4.16 The decline in bank lending reflects limited demand for new credit, although there are supply-side factors as well. Most bank credit is concentrated in restructuring and refinancing operations. This credit has been provided for loan restructuring, capitalization of interest from negative amortization of mortgage loans and appreciation of inflation-indexed loans (UDIs). The intermediation function of banks remains limited-lending has fallen as the economy has recovered. Banking System Stabilized 4.17 The banking system has been stabilized at great fiscal cost -- close to US$50 billion by the government's own estimates. Loan quality remains poor, however, and banks have not been able to generate new, quality productive assets. Sources of funding have improved, however, and their cost has declined (in part reflecting generous deposit insurance), although the weakest banks may still be experiencing negative operational cash flows. So far bank rescue programs have not provided liquidity to banks, which may eventually require an early, partial redemption of some long-term bonds (FOBAPROS, UDIs, highways, ect.). These requirements will need to be balanced against fiscal and monetary constraints. Earnings Quality Poor 4.18 Trading activities and various tax credits continue to be major sources of bank income, while large losses are still being experienced in core banking businesses. Margins are likely to narrow as inflation declines and competition intensifies, while operating expenses (including network expansion, information technology and personnel upgrading) will probably rise. Increased International Borrowing 4.19 Much of the growth in domestic lending anticipated for the second half of 1997 failed to materialize. This is partly attributable to the substitution of domestic with international credits by large exporters. These enterprises reportedly can obtain dollar-denominated financing from foreign banks at rates well below those prevailing among domestic banks. Mexican banks must rapidly become more competitive with international competitors. Sources ofLoan Growth 4.20 Banks anticipate a shift in the structure of their loan portfolios. As large companies continue to finance themselves abroad, domestic banks can be expected to turn increasingly to their traditional client base, Mexico's thousands of small and medium size companies. In 1998, in fact, most loan growth is expected to come from these enterprises. As part of their strategies, there is a need for banks to focus on expansion of their networks to the under-served small enterprises in regional and rural markets. Banks must also move toward greater standardization of mortgage and other loan qualification, a particularly crucial step for the development of asset- 36 backed securities. They must also start sharing information on debtor credit histories to minimize lending to bad credit nsks. Toward Long-Term Banking Stability and Growth 4 21 Efforts to revive the banking system have begun to improve banking performance. While it may take years to develop a sound "credit culture," banks are improving credit reviews, human resources and debt workout capabilities. These efforts have been reinforced by new policies and requirements for credit applications. Although some large banks continue to lend to the same customers, they are willing and able to comply with new information requirements for new lending. Internal credit reviews have changed, and monitoring of credit has tightened. Banks have also introduced stricter guarantee policies. Until the 1994 crisis, large amounts of credits were given as "signature" loans. Today this practice is almost nonexistent. 4.22 Major progress has also been achieved in accounting reform, including redefining past due loans to include the total amount of credit, marking to market non-sovereign financial instruments, adjusting for inflation, introducing market nsk-based capitalization requirements, and progress towards group-level consolidated financial statements. Concerns still exist, however, regarding inter alia lack of valuation rules for debt restructurings and various securities, renewals and extensions of credit to delinquent borrowers, and treatment of adjudicated assets. Consolidation and Foreign Capital 4.23 Consolidation of the banking system and increased participation of foreign capital and foreign banks have strengthened the banking system and increased competition. Banks' shareholder capital must continue to be improved, however, in both quality and quantity. Under differing provisioning assumptions, banks need additional capital sufficient to restore a capital adequacy ratio of 8 to 10 percent (although it would be desirable to raise it to 12 percent over time). In order to minimize unexpected insolvencies of banks and other financial institutions, a sound system of loan-loss provisions must be developed to include, in addition to general provisions, provisions for FOBAPROA loans-related losses, provisions for restructuring credits, and other provisions. Bank's shareholder capital must be increased in both quality and quantity. Need for Additional Capital 4.24 Adding to bank capital will require a continued search for strategic investors for some banks and accelerating the process of bank resolution and/or mergers in others. It will also require increasing paid-in capital through conversion of convertible and other subordinated debts into capital and the adoption of improved capital adequacy standards. Recent proposed reforms would eliminate restrictions on foreign ownership of entities that control financial groups, banks and brokerages. This includes the elimination of the restrictions forbidding foreign financial entities from controlling, under current rules, those banking institutions, the net capital of which exceeds 6 percent of the aggregate capital of all banks. This would effectively permit foreign ownership in Mexico's largest banks. At the same time disclosure of bank transactions, especially with related parties, must be strengthened. 37 Need for Legal and Regulatory Reform 4.25 An antiquated legal framework, which often discourages debt repayment and bankruptcy and does not adequately provide for collateral-based lending, continues to stifle the ability of commercial banks to lend. New collateral rules would be particularly welcomed by small and medium-size companies, since today the only truly acceptable asset to lenders is real estate, a commodity often in short supply among small companies. The rules must concentrate on acceptance and valuation of collateral. These deficiencies are particularly glarng vis-a-vis Mexico's NAFTA trading partners. In addition, updated loan documentation rules are needed to expedite court judgments. (See box below.) 4.26 The CNBV has made considerable progress in strengthening banking regulations, training of staff, adoption of new informational technology and systems, and development of credit bureaus and rating agencies. Major improvements still required include clearer rules and definitions of interest and effective payments; explicit valuation procedures for collateral and for various instruments used in debt restructuring; prevention of direct and indirect refinancing of interest arrears; and specific rules to administer corporate revolving overdrafts. There may be opportunities to enhance the current organization of the CNBV by better visualizing the problems of bank supervision, interventions and resolution, and by segregating the latter two from normal supervision processes. As discussed later in this study, legal reform of the corporate and financial sector is essential to reducing the risk of lending and encouraging the revival and growth of commercial banking in Mexico. Box. 4.2 Loan Documentation: Needed Reform Revisions in the legal requirements for loan documentation are required to support credit growth The poor state of the Mexican judiciary, and in particular the long delays in secunng a final judgment in an enforcement action, places a premium on documenting loans so as to qualify them for expedited enforcement proceedings in court This is normally accomplished through the delivery by the borrower to the bank of apagard (promissory note). Pagards are entitled to expedited judicial proceeding, with limited opportunity for the borrower to present defenses or counterclaims. In the current state of the judicial system, however, even enforcement of such instruments may be quite time-consuming. To qualify as apagare, an instrument must be drafted as an unconditional obligation to pay a certain sum on a specified date or dates Other terms and conditions affecting the amount and timing of repayment (acceleration upon cross-default, requirements to comply with financial ratios, use of proceeds, etc.) may not be included Accordingly, banks relegate these sorts of loan conditions to a separate document (generally described as a loan contract) that must be enforced through full-fledged judicial proceeding, permitting the borrower to propose all sorts of defenses and counterclaims. Enforcement of such terms and conditions is generally impractical. Banks and other creditors have argued for broadening the definition of pagards to permit them to include other conditions that are susceptible to rapid determination by courts in expedited proceedings. B. Other Secured Asset Financing 4.27 As with commercial banks, leasing and factoring companies experienced fast growth in the early 1990s, the result of financial sector deregulation, economic liberalization and expectations of economic growth. But rapid growth in marginal leases prior to 1995 occurred in the absence of adequate controls, both financial and regulatory. Combined with sharp cutbacks 38 in bank credit to these institutions dunng and after the crisis, these shortcomings caused severe contraction in the operations of leasing and factoring companies. 4.28 As is the case for all creditor institutions in Mexico, the growth of leasing and factoring companies have been hindered by the financial sector's underdeveloped legal framework and weak judiciary. In particular, difficulties in securing movable assets, recording appropriate title to them, and collecting secured assets held under non-performing leasing and factoring arrangements have adversely affected the operations of these institutions. Leasing 4.29 Mexican companies have histoncally financed equipment purchases from their own funds. Leasing accounts for just 2 percent of financing in Mexico, compared with more than 30 percent in the U.S. Still, leasing assets-which more than tripled between 1990 and 1994-grew from 1.2 percent of GDP in 1990 to 2.2 percent of GDP in 1994, and the number of leasing companies almost doubled. By the end of 1996, however, leasing company assets had dropped to 1991 levels, and a number of companies had merged or closed. By mid-1997, 11 bank subsidiary leasing companies had been reincorporated into the operations of their bank affiliate. As many as 60 of Mexico's 66 leasing companies have failed. Background 4.30 Leasing companies were first authorized in 1983. Early regulations were so strict, however, that they eventually forced many participants out of the activity. As regulations were eased, leasing company portfolios grew. In 1994 banks were authorized to originate financial leases. 4.31 After the 1994 crisis, leasing companies experienced a severe contraction in their traditional source of capital, the nation's commercial banks. Because most leases were of intermediate duration, leasing companies' demands for borrowing at matching maturities were not being satisfied. Banks demanded greater cash-flow coverage from the income streams related to leasing company borrowings. Leasing companies became increasingly unable to lease because doing so required customers to increase their down payments (or other equity contribution) m order to provide the necessary coverage. 4.32 At the same time, leasing companies saw their capital sources dry up as lessees could not service their obligations. And even if leasing companies could recover their collateralized assets, they had a hard time selling them after the peso crisis. The only advantage of leasing companies during this period was that they had little or no dollar-denominated debt when the peso was devalued in late 1994. To strengthen the capital base of leasing operations, the authorities began encouraging banks to take over failing leasing companies-which in many cases were already bank subsidianes-by merging them with the rest of their operations. Recent trends 4.33 Leasing activities still have not recovered. With large exporters moving toward international financing, leasing has been swept aside. Lease financing reflects many of the legal constraints facing commercial banks, particularly for secured transactions. Because the legal status of leases is unclear, lessors require the execution of promissory notes as well. Given the 39 protracted procedures required to repossess assets, it is often easier for a lessor to collect on a promissory note-assuming the customer is able to pay. The alternative, entering into bankruptcy procedures, is equally expensive and time-consuming. A further difficulty relates to the deficientcies associated with commercial registnes, where title to assets is recorded. (See box below) To reduce the collection risk associated'with lease financing, in recent years leasing companies have shifted their operations from leasing of industrial equipment to leasing of transport equipment, as illustrated in Table 4.2. Table 4.3: Portfolio distribution of leasing companies 1993-1996 1993 1996 Transportation equipment 3.5 28.1 Other goods 17.1 154 Industnal equipment 36.6 14 4 Industrial and commercial real estate 8.5 14.2 Advances to suppliers 5.4 12.1 Computer equipment 10.3 50 Office and commercial equipment 6.1 3.6 Construction equipment 12.2 3.6 Not specified 0.4 3.6 Total 100.0 100.0 Source. CNBV. Toward a Revitalized Leasing Environment 4.34 The legal reforms discussed throughout this paper would reduce the risks of leasing by protecting the property rights of lessors and providing a legal foundation to leasing as well as to the collateralization of assets under lease. In addition, large companies may expand their efforts to increase access to lease financing for small suppliers and customers. Large companies often lease equipment that they rent to small suppliers, such as small construction companies that require certain equipment only infrequently. Large companies may also consider guaranteeing lease payments on behalf of small companies to banks or other lenders. 40 Box 4.3 The Mexican Public and Commercial Registry The Mexican Public and Commercial Registry Systems need to be changed. The traditional manual recording system, still in force in several states, needs to be replaced by a computerized registry system interconnecting the 32 Mexican States. It is crucial to improve commercial transactions and to allow lenders to have accurate information about records in different jurisdictions At present, each state records information using its own system. The current Mexican system has obsolete legal instruments to finance production and lacks modem mechanisms to finance consumption. Consequently, it is imperative to update and improve registry laws an collateral and secured transactions laws because the current legal framework hinders commercial transactions, restncting access to credit and reducing economic growth. Based on the experience of the other NAFTA signatories, Mexico also needs to improve its technology and the training of its personnel to avoid delays in the processing of recording information. The above mentioned problems requires the following measures. * Accelerate the modernization of public and commercial registries to allow a more flexible, efficient and uniform system: - Flexibility will be achieved if public registries are able to record a broader class of property It is urgent to create a new movable registry system that allows the registration of any identified movable assets, tangible or intangible, by item (generically) or serial number - Efficiency will be improved if records are available to the public in a timely manner, if processing records is improved and records are properly preserved In many States, there are inadequate systems to save documents and, therefore, records are not found. - Uniformity regarding the type of recording-keeping method is desirable. * Analyze the secured financing law, related to both movables and immovables This would lead to changes in the civil and commercial laws and to a revision in depth of some aspects of the secured financing laws, bankruptcy and other related laws and regulations. * Review the law on chattles and their registration. Priority must be given to security interests in movables where only limited types of properties may be used as collateral. We recommend the adoption of a single generic concept for all types of financing transactions following the examples of Article 9, Uniform Commercial Code of U.S and the Canadian Personal Property Security Acts. * Merge public and commercial registries to reduce the costs and accelerate access of information At present, there is no need to keep two separate sets of records. Eventually, the incorporation of other registries such as motor vehicles would be desirable. * Link registries throughout Mexico as soon as possible. An electronic commercial registry linked to the U.S and Canada should be created in the near future to encourage and improve the commercial and investment environment Factoring 4.35 Factors provide working capital financing by purchasing a company's accounts receivable. Receivables are purchased at a discount-typically 20 percent of face value-that is refunded if the receivables are ultimately collected by the factor. By selling its receivables, a company speeds the collection of revenue receipts and reduces the Mexican asset tax, since the sale reduces the firm's total assets. Factors also know the customer base in many industries and serve their clients by saving them from selling to non-payers. Factors benefit by bypassing the difficulties associated with seizure of assets under the country's deficient collateral laws. Their real risk is the possibility that receivables purchased cannot ultimately be collected. 41 Background 4.36 Factoring companies were hit harder by the crisis than leasing companies because a large portion of their receivables portfolio could not be collected. Factoring grew quickly during the 1980s and through 1994, but between 1994 and 1996 it dropped 56 percent a year, from MX$37 billion to MX$7 billion. Moreover, between 1994 and June 1997, eight factoring companies were merged with banks and 26 were closed. As of June 30, 1997, 45 factoring companies were in operation. Making Factoring Accessible To Small Companies 4.37 Factoring companies have been trying to increase small companies' access to factoring services. Factors have experimented with issuing notes (instead of cash) in exchange for the receivables of small suppliers. (The suppliers hold the notes or discount them immediately.) In addition, several large companies are providing factoring services to small suppliers. In a process known as "reverse factoring," a large company purchases (at a discount) accounts receivable from small suppliers. In exchange, the large company receives longer payment terms from the suppliers. C. Institutions for Financing Micro- and Small Enterprises 4.38 Mexico contains an estimated 2.1 million micro-enterprises and 50,000 small firms. These companies' already limited access to commercial bank finance has been further curtailed in recent years by the decline in bank lending. A number of small non-bank financial institutions, such as credit unions and savings and loan societies, provide financing to these enterprises, which are often too small to attract the interest of commercial banks. 4.39 In addition, Mexico has a large informal sector, particularly in large cities and rural areas where families support themselves by selling cash crops, trading in informal markets and other small-scale micro-entrepreneurial activity. Until recently, Mexico has been a lagging case relative to a number of other Latin American countries, where the efforts of civil society, non- governmental organizations (NGOs) and, increasingly, specialized, non-regulated institutions have taken a leading role in development of microfinance institutions to serve this sector. In recent years, however, Mexico has begun to develop a vibrant micro-finance sector, with several important example discussed below. 42 4.40 Today in Mexico, three types of non-bank financial intermediaries provide financing to formal-sector micro- and small enterprises and to informal-sector entrepreneurs and entrepreneurial groups: * Chartered nonbank financial institutions, including uniones de cr6dito (credit unions), sociedades de ahorro y prstamo (savings and loan societies) and similar institutions.20 * Specialized microfinance institutions that operate as asociaciones civiles (civil associations) or instituciones de asistencia privada (private assistance institutions), such as Asoczaci6n Programa Compartamos. * Government-induced, group-based credit and savings programs such as cajas solidarias, of national scope, or Microcr9dito Santa Fe, sponsored and promoted by the state government in Guanajuato. 4.41 Except for credit unions, these nonbank financial institutions weathered the 1994 crisis better than other financial sector intermediaries. Their membership and clientele have increased substantially, their portfolios have maintained or improved performance levels observed prior to the crisis, and they have adopted innovative good practices in micro- and small business finance. Credit Unions 4.42 Mexican credit unions closely follow the supply-led model of borrower cooperatives created primarily to benefit from subsidized credit. Despite their name, credit unions have generally not been established as an outgrowth of the cooperativist movement, but as a mechanism for formal sector businesses to obtain commercial and development bank funding, often at subsidized interest rates. Established as associations of mostly medium-size entrepreneurs, in the past their clientele has been estimated at about 250,000 small and medium- size (primarily rural) enterprises. Today they have some 50,000 clients. 4.43 Although technically under the supervision of the CNBV, in practice credit unions operate under the supervision of their main creditor, NAFIN. Between 1994 and 1997 credit unions experienced a sizable drop in assets and portfolio outstanding in real terms (Fig. 4.23). Moreover, delinquency rates soared from 18 percent in 1994 to 46 percent in 1995. Arrears remained at 44 percent in 1996, when a number of credit unions were declared not viable and (apparently) dropped from the aggregate credit union statistics maintained by the CNBV. 20 Credit unions and savings and loan societies are chartered under the Ley General de Organizactones y Actividades Auxtiares de Credito, and are supervised by the CNBV. Cajas Populares and Cooperativas de Ahorro y Credito are registered under the Ley General de Sociedades Cooperativas and are not supervised by the CNBV Detailed accounts of the history and evolution of most of these institutions can be found in Mansell-Carstens, 1995, and World Bank, 1997 43 Fig. 4.2: Uniones de Credito 1994-1997 (II) 20000 15000 10000 r 5000ft W. 1994 1995 Year 1996 1997 Millions of constant pesos 19Tprough June 1997 3 Total assets 0 Loan portfolio, total r Overdue portfolio 4 44 The 60-percent drop in credit union portfolios between 1994 and 1997 reflects not only the erosion induced by the peso cnsis, but also a serious breakdown in the credit union network. NAFIN estimates that about 200,000 clients are not being served because of the near-collapse of the system. A viability assessment carmed out in mid-1996 concluded that of 314 credit unions, 74 were viable and thus eligible for short-term support, 51 were not in operation and were to be liquidated and 189 were to be transferred to the Fideicomiso de Recuperacion de Cartera (FIDERCA, the equivalent of FOBAPROA for credit unions). 4.45 A new program in its final stages of preparation at NAFIN intends, among other objectives, to boost government funding to micro- and small enterpnses through multipurpose entities labeled organizaciones defomento (ODFs). Given its ambitious outreach targets- 50,000 to 250,000 microenterprises in two years-the program nsks creating incentives similar to those that prompted the rapid emergence of credit unions and their subsequent collapse. Savings and Loan Societies 4.46 Cajas populares, the forerunners of today's savings and loan societies, have existed in Mexico since 1951. The rule of "one member, one vote" determines their governance mechanisms, and their lending is funded by member deposits. Membership cuts across a wide range of occupations. Although micro- and small enterpnses play an important role in their lending portfolios, loans are provided to many types of enterprises. 4.47 Upon the passage of the General Law on Credit Organizations and Auxiliary Activities in 1991, the cajas populares could apply to be chartered as Sociedades de Ahorro y Prestamo (savings and loan societies). In 1997 the CNBV had records on 13 savings and loan societies, a decline from 20 in 1995 and 17 in 1996. Not all of these evolved from cajas populares, although the largest-the Caja Popular Mexicana (CPM)-resulted from a consolidation of many cajas 44 that had been members of the Confederac16n Mexicana de Cajas Populares. Most other caj as remained as caj as populares or adopted the legal form of Coopertivas de Ahorro y Credito.21 Wide Branch Network 4.48 Savings and loan societies have a network of almost 400 branches with 500,000 members in 31 states. Two-thirds of the branches are accounted for by CPM, however, and most members are in the state of Guanajuato. Aggregate CNBV statistics for the savings and loan societies show a 40-percent drop in total assets and loan portfolios (in real terms) between 1995 and 1997, and a 36-percent drop in real deposits. But arrears, in contrast with figures for credit unions and the rest of the banking system, improved from 14 percent of the portfolio to 8 percent in the same period. 4.49 These data, however, are slightly distorted by the decline in the number of savings and loan societies included in the aggregates (from 20 in 1995 to 13 m 1997). The average savings and loan society saw only a 10-percent decline in assets and loan portfolio during this period and a recovery in real deposits in June 1997 relative to 1995. Peso-Denominated Loan Portfolios 4.50 Savings and loan societies (and savings and credit cooperatives in general) rely on mobilized deposits to support their loan portfolios. This characteristic of their capital structure protected the societies from the peso cnsis because they had almost no foreign currency liabilities. This gave savings and loan societies an advantage over commercial banks, because they were able to lend when banks were cutting back on credit. Savings and loan societies were also able to refinance credit union customers with credit card and other bank debt. Thus well- functioning savings and loan societies were able to attract new members and grow Post-Crisis Recovery 4.51 CPM, the largest savings and loan society, typifies the fast recovery that some savings and loan societies expenenced after the peso crisis. In September 1997 CPM's total assets were 23 percent larger (in real terms) than in 1994, and it had grown 43 percent since 1995. Moreover, in September 1997 CPM's loan portfolio was 3 percent higher than in 1994-and 32 percent above the 1995 low. Meanwhile, arrears fell from 15 percent to 10 percent of its portfolio. Deposits suffered moderately after the cnsis-a 9 percent real drop between 1994 and 1995-but were 33 percent higher in 1997 than in 1994. (In the banking system deposits in 1997 were 4 percent lower than in 1994.) Membership m CPM increased 81 percent between 1994 and 1997, and the number of branches tripled. Finally, productivity per CPM employee increased 40 percent during this period. 4.52 CPM's outreach to micro- and small enterpnses is substantial. Some 26 percent of its members are entrepreneurs in manufacturing, commerce, or construction, and 18 percent are in agnculture. In September 1997, 42 percent of its portfolio was in loans to enterprises, with an average loan size of $1,500. In addition to credit formally recorded as going to enterprises, a sizable portion of other loans--especially for housing-reach entrepreneurs' households. The 21 This legal form is authorized by a law passed by parliament in 1994, while the Savings and Loan Societies Law was primarily a result of the executive passing a bill through a legislature controlled by the party in power in 1991 45 fundability of finance makes these loans an integral part of CPM's financing for micro- and small enterprises. 4.53 CPM's microentrepreneur customers, having recovered from the 1995 recession, appear ready to expand business. A tannery in Leon, having refinanced bank debt with a CPM loan a few years ago, would now benefit from purchasing new machinery and gaining access to a revolving line of credit. A publicity company in San Luis Potosi could use a more dynamic credit line to face increasing demands for working capital. Further Institutional Development 4.54 The success of savings and loan societies and their interest in growth have encouraged their association to request government support for institutional development, including improvements in regulation and prudential supervision mechanisms, and in setting up deposit insurance. These requests also encompass changes in the fiscal regime that applies to savings and loan societies and, among other matters, in access to rediscount lines. While institutional development and improvements in supervisory mechanisms appear to be justified, access to rediscount lines would require careful scrutiny of the terms, conditions and overall incentives associated with such access. The risk of hampering the performance of savings and loan societies in mobilizing savings should be carefully assessed. 4.55 Concerns about the legal and regulatory framework governing savings and loan societies focus on the non-tradability of voting rights, which has enabled small groups with negligible equity investments to control some societies. Such control has facilitated collusion with management-a situation conducive to collapses similar to those observed in credit unions. Prudential regulation on portfolio allocation, portfolio quality, reserve requirements and allocation of net surpluses also should be carefully examined. 4.56 The near-collapse of credit unons has left Mexico's development banks with few conduits for their lmes of credit to micro- and small enterprises. As a result the government may have a strong incentive to involve savings and loan societies in rediscounting. On the other hand, the state government in Guanajuato seems to be pointing in the right direction: it has entered into an agreement with CPM to expand its branch network in the state with government support for locale and other installation assistance, but without directed lines of credit. Specialized Microfinance Institutions 4.57 Several microfinance institutions have shown impressive growth in recent years. Using group lending methods, these institutions reach large numbers of clients-pnmanly women. Examples include Compartamos, Cajas Solidarias, and Microcredito Santa Fe. 4.58 In 1997 Compartamos had 35,000 female clients, more than twice as many as in 1995. The average loan was $50, and repayment performance was excellent. The program uses state- of-the-art methods and has been supported by private donors, the Inter-Amencan Development Bank, and the Consultative Group to Assist the Poorest (CGAP). (See box below). 46 Box 4.4 Compartamos - Making Microfinance Work Compartamos is a non-governmental organization that provides business loans to poor rural women in southern Mexico By the end of its fifth year of operation in 1997, Compartamos had more than 35,000 clients organized into "village banks" of about 40 women each Clients receive short-term (four-month) working capital loans If clients repay their loans, they become eligible for larger ones, depending on the needs and repayment capacity of their micro-business. The average loan is about $50. Even though clients provide no collateral, default rates have been near zero. Clients comply with their loan contracts because they value the continued availability of financial services from the program. Lending in such tiny amounts results in high administrative costs, and thus requires loan interest rates far higher than normal bank rates Still, Compartamos' interest rates are generally much lower than those of alternative sources, such as informal money lenders Compartamos is funded by grants, including $2 million from CGAP. It estimates, however, that the potential market for its loans numbers more than one million women From the outset, its managers have understood that they had no chance of achieving significant penetration of this market unless they could move beyond the limitations of scarce donor funding. Thus they have pared their costs and raised their interest rates to the point where Compartamos now makes a sizable profit Moreover, it will continue to be profitable even though it is paying full commercial costs on an ever-increasing portion of its funding. Management is studying options for placing operations in the framework of a licenses financial institution so that it can fund massive expansion with savings and other funds captured from commercial markets 4 59 Cajas Solidanas operates in rural areas in 24 states. It works with 158 cajas and has 137,000 members. The average loan is $200, and arrears are nearly 20 percent. With assistance from Desjardins, the program is trying to improve its performance, with an emphasis on modernizing its management information system and improving training. 4.60 Microcredito Santa Fe, which is sponsored and actively promoted by the government of the state of Guanajuato, emerged in late 1996 as a local adaptation of models observed elsewhere (Accion, Grameen Bank, FINCA). In less than a year the program reached almost 24,000 clients in 37 municipahties The average loan is $80, with no arrears. Ambitious goals could compromise the program's performance, although its management information system appears to provide adequate control over lending operations. Recent Challenges 4.61 Despite the recent growth of these and other microfinance institutions, Mexico lags behind many other Latin American countries in developing microfinance institutions to serve the informal sector and the poor. In Bolivia, Chile, El Salvador and Peru the demands of microentrepreneurs and low-income households are increasingly being met by microfinance institutions-specialized NGOs and, increasingly, commercial banks and financial cooperatives. 4.62 Massive government interventions and recent attempts by development banks (especially NAFIN) to channel subsidized credit through credit unions have undermined the development of sustainable microfinance mstitutions.22 Moreover, debt forgiveness programs in rural areas have led to sizable defaults to these institutions and eroded repayment discipline. 22 NAFIN has made available to commercial banks lines of credit for micro- and small enterprises, but disbursements have been minimal because of constraints on the intermediation margins allowed to participating banks, given the small size of these loans 47 Future development 4.63 Government efforts to strengthen micro- and small enterprise finance should focus on building an enabling environment for better financial contracts and services. These requirement are no different from those which benefit all of Mexico's financial sector. In particular, the authorities should create an effective system of registries, develop faster ways to execute loan guarantees and foster an efficient legal framework for loan contracts secured with movable property, business receivables and household durable goods. 4.64 Subsidized credit and debt forgiveness programs should be eliminated to restore financial discipline, especially in rural areas. Doing so would allow established savings and loan societies and emerging microfinance institutions to expand their services to small entrepreneurs and the poor in a sustainable manner. Pnvate commercial banks would also be more likely to provide such services if the lending environment was less distorted. 4.65 Regulation and supervision of nonbank financial intermediaries should be revised to address the governance and credibility problems noted earlier. Thus the institutional development and prudential supervision improvements sought by the savings and loan societies should be supported-with the caveat indicated above regarding their access to rediscount lines. In-depth sector work on the cooperative savings and credit sector, particularly the savings and loan societies, may be needed before more concrete actions can be devised. 4.66 Although specialized microfinance institutions are important mechanisms for providing the poor with financial services, they are serving the low end of the microenterprise spectrum. A small portion of their clientele is engaged in activities other than low-skill self-employment. Efforts to increase access to finance by market-onented micro- and small enterprises will have to involve institutions working in these sectors-for example, savings and loan societies or commercial banks that are able and willing to innovate and explore new market niches.23 23 The'current pilot project (SHCP/World Bank) aimed at expanding financial services provision by commercial banks in rural areas should be closely followed to ascertain its possible application to other types of intermediaries and other market niches Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure 5. PRIVATE EQUITY FINANCING 5.1 With a considerable volume of capital available for investment in Mexico, private equity investors have become a prominent feature of the Mexican financing landscape in the past few years. 24 While these investors evidence the growth of non-bank sources of long-term capital in Mexico today, like other financing alternatives private equity has flowed primarily to the largest firms. As large firms have access to less expensive forms of financing, however, few transactions have taken place. Only recently, as the recovery continues and confidence in Mexico has increased, have private equity investors begun to look past the giants of Mexican industry, to firms that are somewhat smaller but may not have the same range of financing alternatives available. 5.2 While the previous chapter focused largely on enterprise credit this chapter provides several recommendations for broadening firm access to private equity financing. The same legal reforms required elsewhere are key here too -- particularly those that are intended to protect minority investors by ensunng that majority owners act to the benefit of all shareholders. Of considerable importance as well is the continued development of the securities markets in order to provide an effective exit (divestiture) mechanism to investors. The broadening of stock market investors will also have a spillover effect for private investments, as investors will seek out alternative investments to match their nsk/reward profile. (This can be encouraged in part by broadening the tax rule which eliminates capital gains tax on listed securities to include unlisted Mexican securities as well.) 5.3 The strengthening of the economy and the financial sector will encourage increased equity financings. The recovery of the banking system will provide domestic sources of long- term debt to complement and augment equity investment in firms and reduce the overall cost of capital of investment. Given the low demand for private equity funds among large companies and the slow but steady recovery among smaller companies, private equity investors can be expected to refocus their investment intentions to companies other than the very largest. The effect of these developments would be to increase demand for venture capital and other forms of private equity investment. 5.4 Despite recent growth, however, the development of Mexico's securities markets are hampered by the weak legal and enforcement framework that hinders the country's economic growth in general. According to the 1998 CEM, countries that have clearly defined shareholder rights and strong contract and legal enforcement tend to have more developed stock markets. 24 Private equity investors specialize in investing in the shares of pnvately held companies Investments range from direct investment and leveraged buyouts in large companies to riskier venture capital investments in small and start-up companies A distinction can be made between the wealthy individuals and institutional investors that invest in private equity funds, the equity funds themselves, and the private equity management company that may promote and invest in the equity funds 50 Without significant legal and regulatory reform, Mexico's securities markets will be unable to meet the financing demands of the bulk of enterprises. Low Level of Private Equity Transaction Volume 5.5 Despite limited transaction volume, the volume of private equity capital has expanded considerably since the recession. According to various sources, approximately US$10 billion in private equity is searching after deals throughout Latin Amenca.25 While most investors do not allocate specific amounts by country, some estimate that a fifth of this amount, approximately US$2 billion, was available for investment in Mexico in 1997. Of the US$2.95 billion invested throughout Latin America in the first eight months of 1997, US$510 million (as indicated in Table 5.1), or about 17.0 percent, was invested in Mexico. This number represents only 13 transactions (excluding SINCAs -- see below), however, with two large transactions conducted by Hicks, Muse Tate & Furst totalling nearly US$300 million alone. Table 5.1 Private equity investment in Mexico in 1996-1997 Investor Amount invested As percent of Number of (millions of US$)) total value transactions Hicks, Muse, Tate & Furst 327 64.1% 4 Newbnidge Capital 33 6.5% 2 Mexcapital 32 6.3% 2 Advent, GE capital 30 5.9% 1 Bankers Trust 21.4 4.2% 2 Latin American Enterprise Fund LP 16 3.1% 1 Latinvest Strategic Investment Group 7 1.4% 1 All others (mainly SINCAs) 43.6 8.5% N/A Total in 1996-1997 510 100% N/A Source. "Private Equity Investment in Mexico," Mexican Investment Board, December 1997. SINCAs 5.6 In addition to the equity flows addressed above, venture capital funds known as SINCAs invest small amounts of capital in local and regional companies around the country. SINCAs are regulated by the CNBV and must comply with the rules and regulations of the Mutual Fund Act. As of April 1997, there were 53 SINCAs located throughout the country, of which only ten are active. SINCA investments are small; their combined net assets of only some US$30 million but were invested in 130 projects. Of the ten active funds, four are quoted on the Bolsa. Many SINCAs have been mismanaged and are now dormant, with one. or two investments and not in compliance with CNBV regulation. NAFIN has invested in some 33 SINCAs, and manages a SINCA in its own right. Limited Equity Capital for Small Firms 25 Source Latin American Private Equity Analyst, World Bank, interviews 51 5.7 Equity capital for small firms is otherwise particularly limited. SINCAs tend to finance companies with US$3 to $10 million in sales, and they may be the only form of outside equity financing available to companies of this size. SmalJer companies are barely covered at all, as seed capital apd early stage investment capital are non-existent; entrepreneurs must rely on friends and family for financing. Larger companies, with sales over US$10 million, may be financed by a very limited number of venture capital funds specializing in small firms. (Among these are the ING Banngs fund, in which the IFC is an investor.) Finally, a firm may be large enough for an IPO on the small-caps market at the US$20 million revenue level -- larger in size than many IPOs in the U.S. (This option will be discussed in more detailed in the next chapter.) Constraints to Private Equity Investment Growth 5.8 As mentioned earlier, the large firms that have been the pnmary investment targets of most private equity investors have less expensive sources of capital from which to choose. But equity investment has been discouraged by several other issues as well. Most important among these are lack of agreement between company owners and potential investors over issues of pricing, and uncertainties regarding the ability of the investor ultimately to sell company shares. Related issues include inadequate protection of investor rights, and firm unwillingness to disclose financial information to potential investors or to give up even a minority degree of control. Share Pricing And Exit Mechanisms 5.9 Equity investors are generally looking for privately held companies which can offer the potential for an internal rate of return (IRR) of at least 20 to 40 percent (or more for more risky situations). In order to calculate this return, investors must consider the several exit mechanisms they may have available, and the return which could be expected from each. The most typical means of exit are stock market share offerings, sale to a strategic investor, and sale to other shareholders. With shareholders loath to take on large investors and the sale of shares to other shareholders not always possible, the ability to conduct a stock market sale is crucial. 5.10 The growth of the Mexican stock market has increased confidence in public offerings of shares as a viable exit mechanism. Public offerings have become more of a possibility for equity investors today in Mexico than in recent years, given the increased numbers of company willing to sell shares, the high level of international participation in regional stock markets and the increased sophistication brought to local brokerages through participation in international offerings for large Mexican companies. By comparing the market valuation of publicly traded companies in Mexico and in the region to projections of company income, a range of possible public offering prices at which the investor could sell its shares can be estimated for several years hence. Potential returns can then be calculated at various share price levels to determine the maximum prices the investor may be willing to pay for an interest in a company. 5.11 Private equity investors will continue to favor investment in large companies, however, until they are convinced of the liquidity and stability of the stock market, particularly the small- capitalization end of the market, over the long term. This is because a successful share sale requires a sufficient level of liquidity (i.e., a sufficient number of market participants ready to purchase and sell securities) to ensure that the introduction of a relatively large amount of shares into the market does not cause the price of the security to collapse. The substantial growth of the 52 small capitalization market since the beginning of 1997 has been particularly encouraging in this regard. 5.12 Despite this growth, continuing concerns over exit ability still tends to put a damper on prices the equity investor is willing to pay. It is not surprising therefore that disagreerment with company owners over share pricing is often due to what many owners believe to be still- depressed prices (although from the standpoint of the private equity investor, this reluctance is often interpreted as a lack of sophistication regarding appropriate valuation methodology). Complicating transaction negotiation is an unwillingness on the part of many owners to disclose information to potential investors. Many investors do report, however, that owner/managers are beginning to gain an understanding of their valuation methods, to accept the need for diluting their position and to understand that selling a portion of their holdings does not immediately equate to a loss of control. Issues of control, governance and minority rights 5.13 While private equity investors in large companies and LBOs typically participate as minority investors, venture capitalists often demand a control position in an enterprise for the five or so years they will hold the company's shares, and they may pay a premium to get it. This reflects not only the perceived riskiness of the situation but the inadequacy of current legislation protecting minority shareholders. Common abuses in this area appear to involve, for example, transactions with affiliates of the controlling shareholders, misleading and non-transparent accounting and the use of company guarantees for the benefit of the controlling shareholders As a result, many investors insist on an active role in enterprise management, using their representation on the company's Board to instill good corporate governance practice. They may provide advice on a range of issues, including entering new export markets, restructuring operations and renegotiating commercial bank debt. (In many cases, they make their investment contingent on debt renegotiation.) Others investors, however, prefer to see professional management in place so they can play a more passive role. Broadening Firm Access to Private Equity Financing 5.14 Efforts need to take several approaches. Firstly, legal reforms assuring that majority owners act to the benefit of all shareholders, including minority shareholders, need to be enacted. By reducing the risks associated with purchasing a minority position, a greater number of transactions in which investors are willing to take a small, more passive interest will be promoted Secondly, as will be discussed m the next chapter, the market for primary share offerings in the Mexican stock exchange needs to be broadened m order to provide a reliable exit mechanism for venture capital investors. Other important measures for increasing private equity investment include reducing the cost of capital of investments, broadening the nature of the private equity investor and eliminating tax disincentives to investment. Reducing the Cost of Capital 5.15 An appropriately structured transaction should reduce the cost of capital to the enterprise by utilizing the most appropriate financial instruments. Investments such as leveraged buyouts (LBOs) and venture capital are often structured with several layers of securities, some senior in capital structure to others, some collateralized, others "quasi-" equity. In Mexico, with a dearth of bank and other financing, only expensive equity and equity-related fifiancings, such as 53 convertible notes, convertible preferred stock or notes with equity warrants (a type of option), are available today. (These instruments usually carry a lower interest rate, in exchange for the possibility of conversion to equity. They are usually expensive to the enterprise as they may over time require substantial payments of interest in addition to equity.) 5.16 By reducing the cost of capital, more companies would find it easier to meet investor return requirements, encouraging a broader range of firms to solicit such financing. One way to decrease the cost of capital is by introducing a layer of long-term debt to the transaction Debt financing would also increase the total amount of funds which could be included in individual transactions. (See box this section.) Long-term debt financing is generally considered by lenders to be more nsk than short-term debt, as the creditworthiness of borrowers over a relatively long period is less assured and managements do not face the discipline associated with annual or frequent renewals of short-term borrowings. Long-term lending risk is compounded in Mexico given the difficulties of collection of non-performing loans in the absence of functional bankruptcy and collateralization legislation and enforcement. 54 Box 5.1 How Debt Financing Can Broaden The Number Of Venture Capital Investments The following examples are intended to illustrate how the reduced cost of capital attained by the inclusion of a long-term debt component in venture capital transactions enables investment in a broader number of companies Suppose a company with $20 million in revenues and $1 million in net profits seeks to raise $9 million for expansion While larger listed companies in the company's sector are trading at an average price of 18 times earnings, the venture capitalist is reluctant to value the company at more than $9 million. To arnve at this value, the venture capitalist weighs the various risks of investment, including the possibility that the company may not go public in the future The venture capital institution is willing to finance the entire $9 million itself Assuming the firm had issued and outstanding I million shares before the financing, it would have to issue an additional I million shares to raise the $9 million it needs. But existing owners balk at this arrangement, as it would require them to give up a 50-percent interest in the company. What can be done to complete the deal? Here is where the benefit oflong-term debt capital can be seen. The company has cash flow before taxes and non-cash charges of nearly S3 million, and very little existing bank debt, so servicing long-term debt should not be difficult Thus, suppose the venture capitalist agrees to purchase only $4.5 million in shares, giving him an acceptable- to-management 33-percent interest in the company (i.e., $4 5 million in shares vs $9 million held by the original shareholders) The company now raises an additional $4 5 million in long-term debt, for which it has to pay interest only for the first two years, and SI 5 million in principal amount, plus interest, in each of the next three years Not only has this structure enabled the company to limit the venture capitalist's interest to one-third of the company, it has also managed to decrease the cost of capital of the transaction, since the venture capitalist's target rate of return is 25 percent per year, but the interest rate on the dollar-denominated debt is, let's say, 12 percent Thus instead of 25 percent, the weighted average cost of capital was reduced to 18 percent. Now let's look at the same situation in a different way Suppose the company's actual and prospective earnings were not as strong -- it could not return 25 percent a year -- and the venture capitalist doubted whether the company would ever be attractive enough to go public. With the availability of long-term debt, the venture capitalist could structure an investment consisting of "quasi-" equity- long-term debt plus some equity feature to provide the opportunity for additional returns, such as warrants to buy shares at a fixed price in the future. Thus the investor gets current return from interest payments on the long-term debt plus the possibility of additional return when and if the warrants are "in the money." The effective cost of capital to the company is somewhere between the 12 percent interest rate and the 25 percent required on straight equity investments Thus, in this case, a company which could not meet the venture capitalist's minimum rate of return was nonetheless able to raise capital because the inclusion of long-term debt effectively lowered the required rate of return 5.17 One alternative to long-term bank debt is to lower the cost of the private equity investor's own investment funds. In the U.S., this is frequently accomplished through the efforts of the federal Small Business Administration (SBA), which provides long-term debt (and, in recent years, equity capital as well) through licensed intermediaries known as Small Business Investment Corporations (SBICs), usually established and managed by banks or existing venture capital fund managers. The SBA has provided nearly US$10 billion to more than 70,000 small businesses since the inception of the program over three decades ago.26 As SBA funds are less expensive to the equity investor than other sources of investment capital, the lowering of the investor's cost of capital can be reflected in the firm's own cost of capital. 26 These funds, which are available at reasonable rates SBJCs, are exchanged for SBIC debt or preferred equity, which are pooled together, and interests in the pool are sold in the secondary markets 55 5.18 Replicating the SBIC structure in Mexico, however, may be complicated. This is because the method of channeling funds through the SBIC, which involves the sale of interests in a pool of SBIC securities, would be subject to the same difficulties facing the issuance of asset- backed securities in Mexico given the absence of needed legislation supporting the issuance of securitized securities. Targeting New Investors 5.19 Another way to broaden the reach of pnvate equity capital is to target new categories of investors, such as wealthy individuals. In many cases individual investors may require a lower investment return than traditional private equity funds, or may have different industry investment preferences. The securities markets in Mexico have recently witnessed an increase in demand for secunties among wealthy Mexican individual investors, who have also shown an interest in investing nsk capital in venture capital-type situations. In response, brokers have been packaging and marketing a limited number of small pnvate placements of equity and quasi-equity securities of companies still too small or risky to sell as an IPO to these investors. Regulation supporting investor protection regarding these types of investments through minimal disclosure and investor net worth requirements would encourage their growth. (A particular type ofsuch investment, structured around a company soon to go public, is described in the box below) Box 5.2 Building Investor Demand: Pre-IPO Sale of Convertible Notes These private offenngs are structured to enable investors to earn current income while they wait for the company (hopefully) to go public. The securities sale may consist of convertible notes, which the holder could convert into shares at a favorable price following the IPO Furthermore, investors could await the IPO while earning current income. Once the company goes public, investors enjoy a built-in return through the ability to convert the notes into shares at a price lower than the IPO pnce Share prices at IPO are typically higher than in previous financings In the case of these offerings, this is because share demand at the IPO can be strengthened from a variety of sources which did not participate in the pnvate offering. These can include emerging market funds, mutual funds, other brokers and small investors Demand for these types of securities offerings represents a developing sources of equity capital for companies for which IPOs may be somewhat premature The offerings also provide a potential source of liquidity for share trading during and after the IPO. An example of a pre-IPO equity financing is one conducted for a small producer of pastries and other food items Pnor to its IPO in 1997, the company sold a small private placement of convertible notes through a leading Mexican brokerage house The notes were pnced as UDIs at a market rate and enabled the holder to convert them into a fixed and predetermined number of shares In addition, the notes carried a mandatory conversion or redemption in 18 months This feature is intended to mitigate in part investors' risk, because if the noteholders do not convert their notes to shares during this penod (either because the IPO does not take place or because the share price following the IPO declines to a level below the implied conversion price of the notes), the company is obligated to repurchase the notes. When the company sold its IPO, note investors made an immediate paper profit, calculated as the difference between the IPO price per share multiplied by the number of shares received on conversion of the notes, less the value of the notes converted Buyers of the private placement were individual investors and a venture capital fund controlled by the broker's commercial bank affiliate. Proceeds of the private placement were used to pay off bank debt (at a negotiated 30- percent discount). 56 Changing Taxation Rules 5.20 Currently in Mexico dividends and capital gains on stocks listed on the Mexican stock exchange are not taxed, while those received on shares in unlisted companies and shares traded in foreign markets are taxed. While this rule was originally instituted to encourage investment in the stock exchange, broadening the rule to include unlisted securities of Mexican companies would encourage pnvate equity investment in companies by individuals and institutions subject to taxation in Mexico. This would ultimately have a positive effect on the exchange as well, since companies which receive venture capital and similar equity investments are typically more likely to issue public offenngs on the exchange in the future. Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure 6. MEXICO'S SECURITIES MARKETS 6.1 The previous chapter examined the increased presence of private equity capital in Mexico today. We now turn our attention to the more formal trading venues, which have expenenced significant growth in the past few years, even as commercial bank credit has continued to decline. While no more than a few hundred companies have raised capital through public securities issues, and despite recent substantial declines resulting from turmoil in international markets, Mexico's securities markets have demonstrated their potential for serving as an alternative source of capital for domestic firms. The challenge is now to expand access to many more firms.27 This chapter reviews the growth of the trading markets for the various debt and equity securities traded on domestic and international securities markets, and recommends actions for continued development. Sources of Growth 6.2 Several factors have propelled the growth of Mexico's secunties markets. Foreign investments have certainly been one of them, accounting for as much as one-third of the capitalization of Mexican equity markets. Half of this amount is in the form of Mexican shares sold abroad (typically as American depository receipts, or ADRs).28 Large companies are attracted by the stability and liquidity of foreign markets, and by the opportunity to attract investors of international stature. The capital-raising activities of Mexican companies abroad, which have hastened integration with world securities markets, have increased expertise and sophistication in domestic markets. 6.3 The Mexican stock exchange, which has been raising capital for medium-size and large companies since the 1994 crisis, has been actively pursuing the growth of its small-capitalization market. This trading venue, introduced in 1993 and now known as the Mercado para la Mediana Empresa Mexicana (MMEX), has witnessed considerable growth between late 1996 and the market declines of 1998. Despite 1998 declines related primarily to international financial turmoil, trading volume in 1997 was 270 percent higher than in 1996, and the recovery in small-company profits in 1996 and the success of several new MMEX issues has increased investor interest in small-capitalization shares. The MMEX can provide an increasingly liquid trading market in which small companies-those with less than $50 million in capital-could raise equity capital. (Annex C lists the companies in the MMEX market.) 6.4 In additional to the primary and small-caps markets for equities, there are also markets for short- and intermediate-term public and corporate debt issues of up to 10 years' maturity. Though small, these markets serve companies of various sizes, providing an alternative to scarce and expensive bank debt. While the number of firms that have issued securities on the Mexican exchange amounts to no more than several hundreds, anticipated regulatory changes and an increase in securities demand anticipated over 27 The primary market for newly issued equities, for example, has witnessed a significant increase in initial public offerings (IPOs)-from just 3 in 1995 to 20 apiece in 1996 and 1997 28 A depository receipt represents an interest in one or more shares of an emerging market company The shares are held by a developed-market custodian The depository receipt issued by the custodian can then be traded, typically in the custodian's home market 58 the long term from recently introduced private pension funds (afores) should make the Mexican securities market a more viable financing option for Mexican firms. 6.5 Just as elsewhere among the financial markets, the development of the securities markets has been hampered by the weak legal and judicial environment. Improvements in minority shareholder rights, for instance, are a concern for stock market participants just as they are an issue for private equity investors. Measures which can be taken by the CNBV and by the stock exchange itself to protect minority investors are detailed in this chapter. Improvements in this area would make the stock market more attractive for both large and small investors. The Mexican Stock Exchange 6.6 Mexico's stock exchange, the Bolsa Mexicana de Valores (hereafter referred to as the BMV or Bolsa), is the primary venue for securities trading in Mexico. In addition to shares, options and warrants of Mexican companies, the Bolsa trades future contracts and public and corporate debt of various maturities. On December 31, 1997, as indicated in Table 6.1, the market capitalization of the equities traded on the BMV was $156.2 billion. Although this was a 71.8 percent increase over the market cap low of December 31, 1995, it was still 22.1 percent lower than m 1993. These gains have been interrupted in 1998, primarily as a result of international market turmoil, as the market's IPC index declined approximately 53.0 percent in dollar terms in the first nine months of of the year. Table 6.1: Market Capitalization (*) (US$ billions) 1992 1993 1994 1995 1996 1997 GDP 333.8 360.7 374.2 279.4 327.3 N/A Market Capitalization. 138.7 200.6 129.9 90.9 106.8 156.2 (*) Figures as of December 31 Source: Federaci6n Iberoamencana de Bolsa de Valores & Bolsa Mexicana de Valores 6.7 The Bolsa is a private institution which operates under a concession from the SHCP and is governed by the Securities Market Act. Its shareholders consist exclusively of authorized brokerage firms, each of whom owns a single share. In October 1997, there were 32 registered brokerage houses, of which 5 were international. 6.8 Located next to the BMV is Indeval, the central share depository, which also serves as a share settlement and clearing house. Indeval is owned by 58 associates comprised of brokers and large institutional investors. Also nearby is the Comisi6n Nacional Bancana y de Valores (CNBV), the regulatory authority for the banking and securities industries. Quoted instruments 6.9 Capital market instruments traded on the BMV include equities and government and corporate debt instruments. Debt instruments are subdivided between the money market (that is, the short-term end of the debt market) and the capital market (which consists of intermediate- to long-term fixed income instruments with maturities ranging from 2 to 10 years). As indicated in Table 6.2, the money market is by far the most active market, accounting for more than 97 percent of trading volume as of September 30, 1997. 59 Table 6.2: Trading value by type of instrument (US$ millions) Instrument 1992 1993 1994 1995 1996 1997(*) Metals 6 3 1 59 0 0 Money Market 3,535,591 4,551,044 3,828,505 610,712 1,319,193 1,461,025 Fixed income: -Government bonds 376 1,555 212 1,105 -Corp. bonds 14,523 6,168 2,592 75 Total 10,448 17,513 14,899 7,723 2,803 1,180 Shares 44,581 62,671 79,820 35,006 43,293 42,287 Total 3,590,627 4,631,230 3,923,226 653,446 1,365,289 1,504,492 (*) As of September 30, 1997 Source- Federaci6n Iberoamericana de Bolsa de Valores & Bolsa Mexicana de Valores Trading Infrastructure 6.10 Trading in money market and debt instruments takes place through an over-the-counter market. Except for the most active stocks, the trading of equities on the BMV is carmed out by electronic trading on a continuous basis. Electronic trading takes place on terminals located around the trading floor of the Bolsa. There are plans to transfer the terminals to the central offices of broker/dealers within the next twelve months. This improvements should increase liquidity and lower commission fees. 6.11 Although Indeval, the central depository, also acts as a clearance and settlement house for the Bolsa, Indeval does not shelter investors from the risk of transaction (that is, the settlement risk). Indeval is purely a bookkeeper and executioner. It does not settle trades until it has received the cash and the securities involved in a given transaction (unlike more sophisticated settlement and clearing operations which rely on participating banks and brokers to verify buyer funds availability and seller's share title). 6.12 Incomplete, or "failed," trades are not uncommon, particularly for stocks with low liquidity. Among the 10,00 transactions a month, about 200 fail. In volume amounts, failed trades can be significant. To reduce the nsk of such trades, Indeval requires brokers to put up margin (i e , present shares as collateral) according to their monthly trading volume and failed-trade history. 6.13 The Bolsa is in the process of setting up a separate clearance and settlement house. The Clearing House, as it is to be known, is scheduled to become operational in the second quarter of 1998. The leader of the project is Indeval, and the owners of the Clearing House will be brokers and banks. If certain legal issues are resolved, insurance companies may also participate. BMVEquities Trading 6.14 According to the IFC's 1997 Emerging Stock Market Factbook, as of December 31, 1996, Mexico was the world's 23rd largest stock market in terms of market capitalization, the 21st in terms of value traded, and the 38th in terms of number of companies quoted. The main stock index, known as the IPC, comprises 35 to 40 issuers participating in different sectors of the economy. 6.15 As of September 30, 1997, the shares of 195 companies and 306 mutual funds were quoted on the primary listings of the BMV (not including 36 companies traded on the small-cap market). [Update for 60 1998.] The number of companies quoted on the primary board has not changed much since 1992 , as seen in Table 6.3. This stagnation is only partly the result of the financial crisis, since most large capitalizations were already quoted by 1992 and few small and medium-size enterprises have reached the primary board because they are traded on the MMEX instead. In addition, a number of companies have been delisted because they did not comply with the BMV's maintenance requirements. Table 6.3: Listed Companies and Funds(**) 1992 1993 1994 1995 1996 1997(*) Companies 199 190 206 185 193 195 Funds 238 242 259 264 269 306 (*) As of September 30, 1997 (**) In 1995, 1996 and 1997, there were in addition 69, 73, and 73 listed companies, respectively, admitted to trading in foreign securities markets Sources Federation Iberoamencana de Bolsa de Valores, Bolsa Mexicana de Valores 6.16 The number of new issues increased markedly in 1997. As of September 30, 1997, 16 new issues had reached the market, and an additional 4 others were expected before the end of the year. In dollar terms, 1997 was a reversal of 1996, as indicateed in Table 6.4. More than $430 million were raised through new listings, and $270 million through secondary offenngs. [Update for 1998.] Table 6.4: New Issues Of Shares (in USS millions) 1995 1996 1997(*) Capital raised by companies already listed 12.9 440.0 269.3 Capital raised by IPOs during the year -- 217 5 433.8 (*) As of September 30, 1997 Source Bolsa Mexicana de Valores 6.17 Proceeds from new issues were used primarily for investment to fund growth; for balance sheet restructuring, with the proceeds of the capital-raising exercise used to repay corporate debt; and for harvesting of equity investments for founders of enterprises taking advantage of a window of opportunity to sell some of their shares m their companies. (See Annex Cfor the use oflPO proceeds by selected companies.) Share Issues Abroad: American Depository Receipts 6.18 The Bolsa is not the only venue for trading in shares of Mexican companies-particularly for offerings in excess of $100 million, for which Bolsa liquidity is insufficient. These offerings can be sold internationally, most frequently in New York in the form of ADRs, with a tranche of shares reserved for Mexican broker/dealers to offer on the Bolsa. ADR offerings have improved reporting and disclosure standards in the Mexican market, helping to spur the development of domestic securities markets. This can be seen in the higher quality of securities analysis, brokerage reports on client stocks, and other securities business in recent years. 6.19 ADR offerings of Mexican companies totaled $24.1 billion at the end of September 1997. They accounted for nearly half the $53.4 billion invested by foreigners in Mexican securities and about 15 61 percent of the market capitalization of Mexican equities. While ADR issuers are typically large, they are not necessarily active exporters or producers of tradable goods. Issue data indicate that international securities markets may be less reticent in financing nonexporters than are international credit markets. This is understandable, as currency fluctuation can directly affect foreign currency-denominated debt service. The effects of currency changes on equity values are more indirect, based as they are on the effects of currency change on company earnings. 6.20 Depository receipts provide several advantages for portfolio investors. U.S.-issued depository receipts, known as ADRs, must comply with U.S. rules for public securities issues.29 Thus ADRs are attractive to international institutional investors because they significantly reduce local market risk, including clearing and settlement risk and local counterparty risk. And because they can access a much greater pool of investment capital than in their local markets, ADRs provide much greater liquidity to large institutional investors trading m large blocks of shares. At the same time, the willingness of management to abide by the disclosure requirements of ADRs sends an important signal to the market and to other local companies regarding the need for better disclosure and corporate governance. It is hoped that the transparency and disclosure required by ADRs will become commonplace in the local market as local investors increasingly demand the same protections. Small-Capitalization Market 6.21 In an effort to foster growth of the equity markets, in 1993 the BMV opened a second-tier segment called the MMEX market, reserved for small to medium-size enterprises On September 30, 1997, the MMEX market included 36 stocks in two categories. The first category, which accounts for almost all trading volume,30 is made up of 16 companies whose initial public offerings were made through this market. The second, with almost no trading activity, consists of 20 companies originally quoted on the main board but subsequently moved to the MMEX market. Although the MMEX's market capitalization accounted for just 0.8 percent of the Bolsa's total market capitalization on September 30, 1997, between 1996 and 1997 growth in the MMEX market was far greater: 150 percent compared with 54 percent for the entire equity market, as indicated m Table 6.5. Table 6.5: MMEX Market Capitalization (*) (US$ billions) 1993 1994 1995 1996 1997 Entire Equity Market 200.6 129.9 90.9 106.8 164.6 MMEX Market 02 1.0 0.6 0.6 1.5 (*) As December 31 except for 1997, as of September 30 Source: Federac16n lberoamencana de Bolsa de Valores & Bolsa Mexicana de Valores 29 The U.S. SEC permits the raising of fresh capital through the issuance of new shares in the form of ADRs only for those issuing companies which can meet the most ngorous disclosure standards, as required for all pnmary issues in the U S These are known as level-3 ADRs, with level-I and level-2 ADRs requiring lower levels of disclosure but permitting ADRs only in the case where underlying shares were preexisting in the home market As most Russian companies were not "corporatized" until 1992 or 1993, they are only recently starting to be able to meet the level-3 ADRs requirement for three years of GAAP-audited financial statements. It can be expected therefore that in the near future, an increasing number of Russian companies will qualify for level-3 status 30 Trading volume for the first category through the first seven months of 1997 amounted to 861.58 million pesos, or 96 5% of the total volume for the MMEX market 62 Growth in Small-Cap New Issues 6.22 Although the MMEX market remains small relative to the main board, trading activity has increased fairly consistently since its inception, both in terms of number of shares traded and traded value, as set forth in Table 6.6. [Update for 1998.] While this market continued to grow even during recession, small-capitalization markets in developed economies as well as emerging markets are typically subject to wide swings in valuation as investors "flee to quality" during economic downturns, and the MMEX may be subject to such swings itself. Nevertheless, the market offers the potential to be a viable source of equity capital for small firms. Table 6.6: MMEX traded volumes (in millions of shares) and traded values (*) (US$ millions) 1993 1994 1995 1996 1997 Traded volume 1 60 145 236 659 Traded value 2 81 63 165 276 (*) As December 31 except for 1997, as of September 30 Source. Bolsa Mexicana de Valores & GBM Atldntico Obstacles To Equity Market Growth 6 23 Equity markets require further growth in trading to be a viable source of capital for a broad swath of Mexican firms. Encouraging growth in trading largely involves promoting an increase of the variety of issuers and the number of shares available for trading. Currently, share supply reflects the small number of issuers, the small share float per issuer, and multiple share classes, which result in market fragmentation. Although this last issue can be dealt with through regulation, the first two depend on increased enterprise demand for financing through share sales and a willingness to offer a larger portion of shares at public offerings. Small Number of Issuers 6.24 Between 1992 and 1997 BMV's turnover ratio (i.e., the ratio of trading value to total capitalization) oscillated between 33.0 percent and 44.4 percent, as seen in Table 6.7. This is relatively low for a market of BMV's size and maturity. Mature markets often have turnover ratios near or in excess of 100 percent of market capitalization. The BMV figures reflect the lack of liquidity in Mexico's capital market. Table 6.7: Turnover and Turnover Ratios ( as % of market capitalization) (US$ billion) 1992 1993 1994 1995 1996 1997(*) Turnover 44.6 624 79.0 34.6 43.1 42.1 Turnover ratio 37.0 36.8 44.5 33.0 42 5 34 1 (**) (*) Figures as of December 31, except for 1997, figures as of September 30 (**) Based on anticipated annual figures for the year Source IFC 1997 Emerging Market Factbook 63 Small Share "Float" of Typical Issuer 625 A primary cause of the lack of liquidity of the Mexican markets is the small size of the free share float (shares available for trading) of quoted companies. In most cases between 15 percent and 35 percent of shares are floated on the market; the rest of the shares are owned by the founders, who insist on retaining absolute control over the voting rights of their company. 6.26 An increased supply of issues would tend to provide a "portfolio" effect m cushioning the blow of a downturn in share prices. The shareholders of small and medium-size family-owned companies are just beginning to understand that selling a small portion of equity is not tantamount to losing control. They also need to better understand the benefits of raising capital through the stock exchange Primary among these is the chance to increase the aggregate value of their holdings even while owning proportionally less of the company than they did previously. Given the historic instability of the Mexican economy, permanent equity capital may prove to be a far less risky funding source. Over the longer term, liquid securities markets should also have a beneficial influence on corporate governance because they facilitate ownership changes that encourage corporate efficiency. 6.27 Again, however, the lack of legal reforms play a role in slowing the growth in share liquidity. In this case, the murky legal rights of minority investors account in part for the reluctance of owners to decrease their ownership and for many direct, or strategic, investors to demand a controlling interest. By maintaining control, they avoid ending up in a position where their rights are unclear. Thus we see an example of how the lack of an appropriate legal foundation can result in enterprises being denied needed capital. Until the conditions that reinforce the "control" mentality change, there is little scope to significantly improve the Bolsa's liquidity. Obstacles to Public Offerings 6.28 Market swings and the lack of liquidity often mean that share offerings must be delayed long after they have been approved by the CNBV and the Bolsa. These cases are sufficiently common that a special listing, known as the listado previo, has been created for companies awaiting public offerings. The listing requires these companies to keep their registrations current by fulfilling public-company disclosure requirements. 6.29 For these reasons many offerings are conducted on a best efforts, rather than a firm underwriting, basis.31 While rules for underwnting have been promulgated by the CNBV, they are high-risk, time- consuming efforts. Successful share underwriting requires a high level of market demand to facilitate the determination of the offering price, often difficult in the Mexican market. For these reasons brokerage houses prefer simply to sell as much as the market will take at an agreed price. Brokers make sure that "underwriting" contracts have sufficient "outs," a common practice in developing markets, and in any event there is little precedent regarding enforcement. 31 At an underwritten public offering, financial institutions guarantee the issuing company an agreed offering price and fixed number of shares to be sold Best efforts offerings are conducted without such guarantees In developed markets, best efforts offerings are rarely used except for offerings of the smallest firms. Less developed markets lack the stability and liquidity which enable financial intermediaries to assume the risks of underwriting. 64 Multiple Share Classes 6.30 Mexican companies can issue several classes of shares, depending on the nature of their industry and their target shareholders. "A" shares are reserved for Mexican investors, "B" shares are for foreign investors, "C" shares are issued by financial institutions, "N" shares are issued by industrial companies, and "L" shares have limited voting rights. 6.31 Different classes of shares in the same company trade at different prices, and each class enjoys different trading volumes and liquidity. While the price differentials are not necessarily irrational, multiple share classes create confusion, cause difficulty in valuation, and hamper the development of liquidity in stocks. In addition, they preserve the image of the market as hostile to foreign or minority shareholders. Attempts to issue Mexican-only shares to foreign shareholders have, in fact, led to schemes such as Certificados de Participact6n Ordinaria (CPOs)-ordinary participation certificates in which the voting rights of the Mexican-only shares are stripped and deposited in a trust, while the CPO-holder gets all the economic rights. The 195 companies quoted on the BMV have more than 400 different shares listed. As previously recommended by the World Bank, regulators should accelerate consolidation and reduce market segmentation. Restrictive Llisting Requirements 6.32 Attracting new issues to the primary board and to the MMEX will require reasonable listing standards that are not so strict that attractive but small companies are turned away. Table 6.8 compares the current listing requirements of the primary board (referred to as "Section A") with those of the MMEX ("Section B"), with changes proposed in this study. While current requirements are intended to provide full disclosure and a minimum level of share liquidity, they may be too restrictive. Table 6.8: Current and Proposed Bolsa Listing Requirements Section A Section B Requirements* Current Proposed Current Proposed Audited financial statements Last three years Last three Last three One year, no years years requirement for startups Mminimum stockholders equity in UDIs) 125 million 50 million 20 million 5 million Minimum free float in the 15% 15% 30% 20% market Minimum number of 200 100 100 50 shareholders Operating income requirements Cumulative of Cumulative of Cumulative of No the last three the last three the last three requirements years must be years must be years must be positive positive positive * Refers to requirements following public offering 65 6.33 Requirements on the size of stockholders' equity and free share float are among the standard listing requirements of mature stock markets. Their adoption by the Bolsa reflects the preoccupation of regulators with ensuring a minimum degree of liquidity in Mexican stocks Given the propensity of issuers to retain control of their equity,32 these requirements are useful. But the value in pesos of the minimum amount of stockholders equity required for a Section B listing appears high relative to the average size of Mexican companies. 33 In addition, there is no possibility that new companies or those still in developmental stage, with little history and a lack of profits - typical of many high technology companies -- may raise capital. 6.34 Proposed changes in listing requirements would permit companies with limited operating histories and a limited number of shareholders to raise equity capital. The changes presuppose that investors will rely on the content of full-disclosure prospectuses to make their investment decisions rather than predetermined minimum listing requirements. These changes therefore go hand in hand with a full CNBV review of the adequacy of prospectus disclosure. Money Market and Fixed-Income Securities 6.35 Another alternative for owners reluctant to give up any degree of control-provided they have sufficient cash flow to service debt-are Bolsa-based money market and fixed-income securities These markets also provide an alternative to equity issuance when interest rates are relatively low and enterprise managers believe their shares would be undervalued if issued. Several hundred companies, many without listed equities, have raised debt capital by tapping Bolsa-based markets for publicly traded debt instruments. The money markets trade short-term (less than one year) debt issued by government, industrial and financial institutions. The fixed-income markets trade intermediate-term (three- to five- year) promissory notes (pagar6s) and longer-term (more than five years) government bonds and corporate debentures. Fixed-income securities have similar issuance requirements as commercial paper, although an offering memorandum must be distributed to institutional investors. Money Markets 6 36 Money market trading takes place primarily in short-term treasury instruments, which accounted for three-quarters of money market trading value in 1997. Much of the balance is taken up by bank financing. Paper issued by bank holding companies, representing nearly one-third of trading value in 1996, declined 15 percent in 1997. At the same time, short-term banking paper (promissory notes and bankers' acceptances) grew nearly 80 percent in 1997. This pattern reflects the high level of bank restructuring activity at the group level in 1996, while by 1997 banks began to increase their lending capacity by borrowing in the debt market. 6.37 Trading in money markets has increased substantially in the first three quarters of 1997 relative to the same penod in 1996 Government issues rose nearly 60 percent, and corporate commercial paper, while representing just 2 percent of trading value, rose nearly 80 percent. This jump reflects an increase in enterprise demand for new debt issues resulting from the general decrease in interest rates on new debt issues. (CETES rates dropped from about 22 percent at the end of 1996 to 17 percent at the end of September 1997.) 32Typically, the free float of a company is between 25% and 30% of its total number of shares in issue 33 Particularly since UDI 20 million translate into almost Pesos 40 million as of October 1997 66 6.38 Commercial paper can be an attractive alternative to short-term bank working capital financing because it is easier to roll over than bank credit lines and less complicated to issue. Instead of a banker supervising a loan account, a less obtrusive trustee represents the interests of the commercial paper holders. Banks provide their guarantee on behalf of a corporate client issuing commercial paper, although company shareholders are often asked to make cash deposits to back up the guarantee. Guarantees enable the banks to exceed legal lending limits to individual issuers because guarantee provisions are not included in limit calculations. Fixed-Income Securities 6.39 Markets for intermediate- and long-term debt securities are much smaller and less liquid than the Bolsa's money markets. These markets consist of public sector debt (28 percent of value in 1996) as well as corporate debt. Corporate issues tend to be industrials, banks and financial groups, and leasing companies. Private sector financing fell in 1996, reflecting a weak market for corporate issues following the crisis, but increased about 25 percent in the first three quarters of 1997, as set forth in Table 6.9. As in the money markets, enterprise demand for intermediate- and long-term debt is up because of the decline in interest rates. Table 6.9: Market Value of Fixed-Income Securities (US$ million) 1995 1996 1997(*) Public sector (Federal Govt Bonds) 1,429 2,511 3,308 Private sector 9,492 8,748 10,894 Total 10,920 11,260 14,202 (*) As of September 30, 1997 Source- Federac16n Iberoamericana de Bolsa de Valores & Bolsa Mexicana de Valores 6.40 Promissory notes, known as pagar6s, are usually two to three years m maturity, priced at 300 to 400 basis points above the CETES rate and sold at a discount. Longer-term issues, typically three to seven years, are generally corporate debentures (senior, subordinated, or convertible). A large number of subordinated and subordinated convertible debentures have been issued by banks. In 1996 in particular, a considerable amount of new medium-term financing related to bank restructurings. 6.41 Markets for corporate debt are small and illiquid due to a lack of investor demand for these securities and an insufficient number of issues trading. Over the long-term, investor demand is expected to grow following the introduction of the afores, which will be limited to investment-grade fixed-income instruments for the first several years. Continued interest rate declines should attract more issuers to market. Several areas require attention. These include legal reform, in terms of creditor protection and asset secuntization, and the standardization of debt ratings. Each proposal will reduce investment risk, and have a positive effect on interest rates and demand for fixed-income securities. 6.42 Legal reform would protect the rights of creditors. The protracted and expensive procedures required under the bankruptcy code raise the risk that creditors will not be able to recover their assets. This presents difficulties for a large or lead bank with nonperforming loans, but it makes the position of a small creditor holding nonperforming fixed-income securities even more untenable. The situation is exacerbated by the uncertain protection afforded minority rights. 67 6.43 Securitizing debt instruments requires clear rules. While most issues are unsecured, a small portion has been secured by corporate assets. These include secured pagares and CPOs, which are issued by a trust that holds title to the collateralized assets. In some cases these collateralized instruments have been used by small financial intermediaries (financing mortgages and transport equipment) that may have been unable to raise debt on an unsecured basis. The ability to issue secured debt has important potential for small and medium-scale financial and industrial firms. Only recently has one large retailer issued securities collateralized by customer receivables, and not without legal risks surrounding unclear regulation. (See box below.) 6.44 Although technques of asset securitization are well known to the Mexican financial community and major industrial and commercial companies, active primary and secondary markets for asset-backed securities have been slow to develop. Almost all the securitization transactions carned out have involved essentially external financings--that is, the packaging and selling of foreign receivables held by Mexican firms. These mainly dollar-based transactions have been governed by foreign (usually US) law and marketed to foreign investors.34 Future cash flows, including payments under power contracts to US utilities (CFE), credit card receivables on accounts of purchases made by foreign tourists (various Mexican banks), oil export receivables (Pemex), and payments from international long-distance carriers to domestic telephone companies (Telmex), are assigned to a special purpose trust or corporation that issues the secunties and applies the cash flows on the transferred assets to service the securities. By organizing the special purpose entity outside Mexico and providing that the cash flows never enter Mexico, it has been possible to receive high ratings without Mexican country risk. 6.45 Until recently the few successful securitizations of domestic receivables were sales of toll-road receivables and securitization of development bank loans. Under the toll-road schemes, future peso- denominated receivables (tolls payable by motorists) were assigned to a Mexican trust. The trust issued participation certificates payable in dollars but governed by Mexican law. Over-collateralization increased the marketability of the certificates, with only a portion of the projected receivables necessary to service the certificates. Additional protections (reserve funds, exchange contracts) were used to mitigate the risks of lower than projected road usage and currency fluctuations. The toll road issuances were not widely replicated, in part because of disappointing performance, problems with market acceptance of the participation certificate instrument (see below), and general market conditions. 6.46 In addition, there are other challenges to secuntizing peso-denominated assets issues relating to standardization and quality of the assets; problems with transferring assets to the entity that issues the securities; shortcomings of the para-financial services infrastructure required for assessing the quality of securitized assets; legal/regulatory limitations on the types of securities that may be issued; capital adequacy rules for credit institutions that hold or provide enhancement for asset-backed securities; and tax treatment of asset-backed transactions. 6.47 A series of new regulations, procedures, and support services are needed to enable asset securitization, permitting the issuance of asset-backed securities. These would include rules on standardization of asset quality requirements, rating procedures, and issue registration; transfer of legal 34 In an effort to take advantage of interest rate differentials, a number of Mexican financial institutions established schemes for the issuance of dollar-denomnated bonds backed by peso-denommated Mexican government securities. Enhancements of various types, including senior/subordinated structures, exchange rate swaps and reserve funds were employed to increase the value of the securities sold to investors under such schemes. Although such offerings were in structure similar to asset-backed transactions, in economic terms they functioned and were marketed more like denvative transactions. 68 rights of underlying assets, including the elimination of costly and time-consuming notarization procedures; and clarification of taxation issues. Services necessary for the development of asset-backed secunties will also be needed. These include credit bureaus, asset appraisers, and trust services. (See Annex Efor a more detailed discussion of these issues.) 69 Box 6.1 Obstacles to Issuance of Asset-baclied Securities: The Tale of One Offering Deficiencies in the legal/regulatory framework for asset-backed securities were identified by the Bank in the work conducted,for the Legal System Policy Options Paper in 1994. In connection with the Financial Sector Restructuring Loan (FSRL), the Bank staff worked actively with the Mexican authorities in 1995 to identify the remaining obstacles to asset-backed securities and produced a matrix ofpolicy actions. SHCP hired an outside US consultant with experience in the mortgage- backed market to prepare the study required as a condition of the-FSRL Subsequently, substantial progress was made in addressing the obstacles to creating a primary market in asset-backed securities identified by the Bank and the authorities After an eighteen month effort, Banca Serfin and Elektra were able in June 1997 to arrange the necessary approvals and regulatory interpretations of Banco de-Mexico, CNBV, Nafin and the tax authorities t6.bnng to market an offering of securities back by receivables. The securities represent-interests'in a trust, the assets of which are receivables originated by Elektrafin,the finance affiliate of Elektra, a Mexican appliance retailer. The transaction was structured along US lines, with senior and subordinated interests (CPOs) registered with the CNBV and offered to the public. The senior securities received an investment grade rating from the local affiliates of two internationally-recognized rating agencies The year-and-a-half-long process of securing the necessary approvals (referred to by one participant as a veritable calvary of red tape) highlights the' remaining steps the government must take.to facilitate.the development of a primary market in asset-backed securities All of the issues presented by this transaction.were ihcluded in the matrix of policy actions prepared by the World Bank team in the summer of 1995 for the SHCP team working on secuntization. The regulatory obstacles encountered by Elektra and the steps required to remove them are: . 1 Banco de Mexico ordinarily requires that a bank'that manages a trust deposit with the central bank a non-interest- bearing cash reserve. Serfin and Elektra had to request an.exemption from this requirement: Banco de Mexico should issue a regulation of general application providing that a trust esiablished to issue asset-backed secunties is automatically exempt from this requirement. 2 CNBV took an extensive amount,of time.reviewing the terms of the public offering and the level of disclosure required. This is not surpnsing given that it was a case of first'impression. The CNBV could accelerate this process by issuing rules of general application for registration of asset-backed securities and disclosure requirements. 3 Trusts which issue securities are required to receive an official appraisal of their, assets by a development bank The investor protection purpose of this requirement is unnecessary given CNBV disclosure requirements and the ratings required by the market [This requirement mnay also,permit the.development bank to require as a quid-pro quo that they be hired as the trustee.] 4 Law firms were unable to provide Serfin and Elektra with clean legal opinions as to the tax treatment of Elektrafin (the transferee of the assets) or the trust: A-special tax interpretation (dictamen) of SHCP had to,be requested. SHCP needs to issue a regulation of general application that clarifies the tax treatment of all partiesinvolved in the asset-backed securities scheme While the above discussion.highlights the continued high costs of bringing.a successful asset-backed security to market in Mexico, it also demonstratesits legal feasibility and that there are in fact a fewconcrete steps that can be taken now to reduce uncertainties and make the process quicker and cheaper. 6.48 Debt ratings require standardization. Individual and institutional investors typically rely on ratings provided by independent statistical rating agencies. Indeed, legal investment regulations, such as those for banks, insurance companies and pension funds, often severely limit the ability of such entities to invest in secunties that have not received an investment grade rating from a recognized rating agency. CNBV regulations require that all publicly offered debt securities be rated, and in the past few years Mexico's rating agencies have increased in size and sophistication. Standard & Poor's and Duff and Phelps have established active subsidiaries in Mexico. 6.49 Neither the CNBV nor Mexican rating agencies, however, has established clear standards for assigning ratings to commercial debts, and there have been a number of defaults on highly rated securities. Policy makers must ensure that there is a clear understanding of what cntena are being applied so that investors have an idea of what comfort they can expect from a secunty's rating. 70 Building Sustained Investor Demand 6.50 Encouraging greater demand for securities is a key ingredient to increasing liquidity and capitalization. Improvements would increase firm demand for share sales because they would promote higher firm valuations, effectively lowering the cost of equity financing. Similarly, increased investor demand for corporate debt instruments would bid up security prices, resulting in lower interest costs. Measures to promote investor demand include building up financial intermediaries, such as private pension funds, insurance companies and other intermediaries that channel investor demand. Mutual Funds 6.51 Mutual funds are not nearly as popular in Mexico as they are in the United Kingdom (where they are known as unit trusts) or the United States. There are 261 mutual funds invested in fixed income (172) and common equities (85). For historical reasons, Mexican mutual funds are nearly exclusively managed by commercial banks,35 which use their extensive branch networks to market the funds. Funds were set up under the trust company act as open joint-stock companies (SA de CV). Most funds are open ended, although some are interval funds (that is, they can be redeemed only at specific times during the year). 6.52 Mutual funds have failed to attract much savings. They have been poorly marketed and are not viewed as attractive investments. Fixed-income funds (bonos con valores constantes), heavily invested in lower-rated leasing-company paper, have suffered several defaults over the years. No "Chinese wall" separates the management of banks and their mutual funds, and banks have been accused of using mutual fund resources to shore up companies with poorly performing loans. 6.53 Competition in the mutual funds industry has not been determined by fund yields. Instead, competition has come from banks which, despite being the main sponsors of mutual funds, regard them as competitors. In the words of one CNBV official, the benchmark has been the checking account. 6.54 The CNBV plans to produce new legislation to govern mutual funds The new law is expected to go to Congress in 1998 or early 1999. It should include measures that would eliminate the conflicts of interest between mutual funds and banks by placing mutual funds at arm's length. The law is expected to make mutual fund operations more transparent by requiring that individual accounts be opened at Indeval to give the CNBV a detailed picture, in real time, of the portfolio of secunties of each mutual fund. The calculation of net asset values would have to be prepared by independent and reputable third parties. The law is also expected to prohibit mutual funds from investing in shares owned by their sponsors or clients or their sponsors. - 6 55 Other measures contemplated in the law aim to improve the dissemination of information to the public, to widen distribution channels, and to foster competition among mutual funds. The latter implies putting in place fee structures to encourage brokers to distribute mutual funds that do not belong to their own financial group. The new law will also ensure that sellers are qualified to advise their clients on the benefits and risks of these types of financial instruments. This means that a process of certification of the sellers must also be put in place. Also under the new regulations, mutual funds will be required to be rated by independent rating agencies to ensure that they comply with the investment rules specified in their prospectus. 35 Banks initially founded mutual funds as a way to avoid extremely high reserve requirements -- as high as 97 5 percent during inflationary periods -- on capital available for investment. 71 Pension Funds (Afores) 6.56 The introduction of new private pension funds, the afores, will likely lend credibility to and stimulate demand for Mexican securities, though they will only be permitted to invest in fixed income securities in their first few years. 6.57 To prevent excess exposure to particular issuers, afores will be limited, at least initially, to investing a maximum of 35 percent of fund assets corporate, commercial bank, or development bank debt, and no more than 10 percent of a single issuer. Afores will also be limited to investing in more than 10 percent of the total securities of a single issuer or m any single issue, and to 15 percent of the assets of a single financial group. Emerging Market Funds 6.58 Emerging market funds, which involve international portfolio investors in publicly traded issues, have provided a large source of demand for securities. Emerging market funds and other foreign investors represent nearly half of foreign investment in the Mexican equities markets. Many funds, based in the U.S., invest on a regional basis, covering other countries in addition to Mexico. There are, however, several U.S. funds investing exclusively in Mexican equities. One of the foremost among such funds in the Mexico Fund, which runs a series of funds of varying risks and securities Buyers are both Mexican and foreign, mostly U.S. institutions and individuals. Foreign individuals and entities account for 32 percent of all investors, less than before the 1994 crisis but increasing of late. In mid-1997 the fund was 92 percent invested in Bolsa-based securities, including public and private sector debt issues and Mexican company equities. Individual Investor Participation 6.59 Direct investment by individual Mexican investors is minimal. There are only about 147,000 equity accounts with Mexican brokers, of which 70 percent (102,900) are held by foreign investors (mostly institutions) and the balance (44,700) by Mexican retail investors. Broadening shareholding among small investors would help increase market liquidity. This would most effectively be accomplished in the context of large privatization initial public offerings expected in the near future. As has been done in many other countries, a significant portion of shares in large offenngs can be reserved for subscription by individual investors, who could be offered special incentives (such as discounted prices) to participate. 72 Box 6.2 Broadening Investor Participation in Public Offerings in Mexico The following discussion presents suggestions for broadening the participation of the population in large privatizations and other public offerings on the Mexican stock exchange The World Bank can provide technical expertise for the implementation of these measures Although Mexican brokers have considerable experience in selling shares of public companies through the Mexican stock exchange, substantially all public offenngs have been placed with domestic and international institutional investors, while individual investors have for the most part been ignored. As a result, the retail component of the Mexican shareholder base is abnormally small considering the size of the market, accounting for to a large degree the low liquidity of the Mexico stock market and the limited demand for new equity. -If this trend could be reversed the benefits to the market could be substantial. The stock exchange can take specific measures to increase retail investor participation in large public offerings These measures are addressed below. I. Selection of candidate In order to generate interest from a large spectrum of the population, the size of the company, its name recognition and prospects for the future are all important. An example of a privatization issue which would be an ideal candidate for retail investment might be the Mexico City International Airport. Preferably, a strategic investor should already be in place, though if the existing management is of high caliber, a Group of Stable Shareholders (GSS) could be put in place instead. The important point is that the future of the company as a going concern needs to be secured before the shares are offered for sale to retail investors. 2 Informational campaign. An intensive nationwide communication campaign through television channels, radios, the daily newspapers and the financial press, as well as billboards,,posters and stickers should be run approximately two to three weeks before the opening of the subscription period (The World Bank could help in preparing the terms of reference for the selection of the communication advisor and perhaps provide financing for this exercise.) 3 Pricing. A pricing committee should beput in place regrouping the issuer, its lead broker or underwriter and the members of the underwriting syndicate. Experience of an international investment bank in large offerings targeted to retail investors will prove valuable in structuring the pricing committee. Various pricing techniques used to attract small investors have been developed by countries of the European Union in the context of their privatization programs. In particular the French have developed a system whereby the book building exercise is widened to include non-binding expressions of interest by small investors through the retail banks. This is particularly useful for pricing the shares as a function of the overall demand for the issue. Consideration could also be given to pricing the shares with a differential between the offer prices for retail and institutional investors. This has been tried successfully in the UK as well. As a general rule, the shares should be priced "generously," so that the share pnce gains 25 to 30 percent in the secondary market in the immediate aftermath of the primary issue. This is essential in order to attract retail investors to the stock market and create a population of shareholders who will continue to invest their savings in the market. 4 ,Subscription rules Subscription rules should be finalized with the financial advisor at the time of drafting of the prospectus. These rules should of course be included in the prospectus The following guidelines could be used to structure the issue. The shares should be offered for sale in two tranches, one for retail investors and the other for institutional investors, with the lion's share of the issue -- 60 percent or more -- reserved for retail investors In case of over-subscription by retail investors, the issuer would reserve the right to scale down ("claw back") the institutional tranche by a maximum of 50 percent. The number of shares offered for sale should be adjusted by means of a stock split and/or incorporation of reserves into the share capital so that the price per share is relatively low and therefore likely to attract low income investors Consideration could also be given to issuing partly paid shares if the issue price is still high after the stock split. 5. Subscription mechanism. The shares should be offered to retail investors through the retail branches of commercial banks, which should be organized into a syndicate. The postal-savings bank could also be used for this purpose. Staff of the banks in the placement syndicate should receive some formal training in order to be able-to advise their clients on the merits and the risks of the proposed investment For retail investors, subscriptions could consist of a minimum and a maximum number of shares per applicant. No more than one application per person (The institutional tranche, however, should not be structured with a unimum or a maximum number of shares per investor.) 6. Share allocation rules. In the case of large privatizations, in order to demonstrate the political will of the Mexican Government to small investors, the following allocation rules should be put in place. First, all retail investors should be served the minimum number of shares; the remaining shares should then be allocated on a pro-rata basis. For this exercise, a computer program could be used to identify multiple applications and eliminate them. 7. Limiting flowback/fostering long term savings. In order to encourage retail investors to become long term investors, an incentive could be given to them in the event that they do not to sell their shares for a fixed period of time For example, consideration could given to give investors one free share for every ten shares not sold for 24 months. 73 Securities Market Regulatory Regime 6.60 The CNBV is the result of the merger of the banking commission and the securities commission. It was set up in the context of the banking cnsis, and most of the attention of the new institution was focused on banks rather than securities. In addition, senior securities specialists left the CNBV at the time of its inception, leaving a gap of competence among regulators. Despite the historical circumstances that dictated the current institutional setup, however, the CNBV should not necessarily revert to its old form. 6.61 The argument for creating a single institution to oversee both industries is that the nature of the financial services industry has changed in the past 10 years. Because of increasing overlap in activities, the distinction between commercial banking and investment banking and secunties activities is often inadequate to describe the nature of financial institutions. Separating the regulation and the monitoring of the two activities would prevent regulators from having a complete picture of global financial institutions.36 6.62 This does not mean that there is no need for more independent regulation of securities market participants and issuer disclosure. It would make sense to consider creating an identifiable and separately responsible entity within the CNBV to be accountable for securities market regulation and supervision. To be effective, a regulatory authority for the financial services sector must fulfill several conditions. It must be independent from those it regulates, have the financial resources and the latitude to hire highly skilled staff, have the means to enforce discipline, and enjoy a degree of self-regulation to ensure that regulations are not disconnected from the market. The CNBV is aware of these requirements and plans to implement them in the near term. 6.63 Over the past two years measurable progress has been made in disclosure standards for issuers Prospectuses have attained an enviable level of completeness and accuracy relative to those in other emerging markets, though they fall short of international standards. Further improvements, now at the planning stage, would fill in remaining deficiencies. 6.64 The CNBV is focusing its efforts on improving the investment environment. Proposed reforms would require disclosure of the trading or acquisition of more than two percent of an enterprise's ordinary capital stock. CNBV has also set the following immediate goals: * Developing modem rules and regulation for Mexican mutual funds and installing a surveillance system to enforce those regulations. * Implementing better disclosure standards for prospectuses and introducing the concept of material information. * Addressing the issue of corporate governance by limiting the use of nonvoting stocks. * Introducing rules and regulations to protect minority shareholders. 36 It is uncommon to place the regulatory authonties for the banking and securities industnes under the same supervision However, the British government has recently changed its approach on the subject and followed the direction followed by the Mexican authorities It has created a single regulatory institution to oversee both industries. 74 A range of additional measures can be implemented to improve investor protection. These include:31 * additional disclosure requirements, including related party transactions and management compensation; * tighter accounting standards; * implementing arbitration standards; * requiring inclusion outside directors and improved shareholder voting nghts and requirements. 37 These measures are largely taken from the 1998 CEM, where they are discussed in greater detailed. Mexico: Strengthening Enterprise Finance Toward Reform of the Legal and Regulatory Foundation of the Financial Infrastructure 7. LEGAL REFORMS FOR FINANCIAL SECTOR GROWTH 7.1 The reform of several important laws would provide greater protection of property rights and assurances for legal recourse in the event of default. These reforms would reduce the nsks of lending and investing, increasing the availability of funds for a broader range of Mexican companies, and lowering their cost of capital. Without these essential and long-overdue reforms, Mexico's financial system will continue to be unable to provide the heterogeneous range of debt and equity instruments necessary to financing an economy of its size and diversity. 7.2 This chapter discusses proposed legal reforms -- in the areas of bankruptcy, minority investor protection, secured transactions and corporate form -- essential for the growth and efficiency of all of Mexico's financial markets. It also reviews weaknesses in the judicial system which prevent effective legal enforcement and provides recommendations for its strengthening. Bankruptcy 7.3 Even before the recent economic cnsis, it was clear that the Mexican Bankruptcy Law, enacted in 1943 and last amended in 1982, was an ineffective instrument for orderly workouts or liquidations of troubled companies. Almost since its enactment, the law has suffered pointed criticism from legal academics, the lending community, and the practicing bar. Most often, critics cite vague drafting, poor logical structure, cumbersome and impractical procedures, and detachment from the practical realities of Mexican commercial and legal practice. One well-respected legal scholar has written that "We believe that it is the worst law that has been enacted in the history of Mexican law."38 Another states m his textbook that "In summary, we know of no one who believes that [the Bankruptcy Law] is a good law, nor even a mediocre [law]."39 7.4 The complicated and expensive procedural requirements of the Bankruptcy Law have permitted many debtors to stave off collection efforts almost indefinitely under the law's provisions for "temporary" suspension of payments. Some of the Bankruptcy Law's substantive provisions, particularly the priority accorded to labor claims (Mexican labor law provides for generous severance benefits for terminated employees) and taxes (regardless of whether a tax lien is in place), combined with the slow pace of Mexican litigation, have made it disadvantageous for lenders to force a debtor into bankruptcy. In fact, the threat of filing for bankruptcy or suspension of payments is often employed by borrowers to force lenders to renegotiate debts. 7.5 As a result of the glaring defects of the law, lenders and their lawyers have generally chosen to resort to other strategies when dealing with insolvent debtors. This in turn has impeded the evolution of a more fully developed jurisprudence in the area of bankruptcy. The uncertainty that results from this state of affairs surely imposes additional costs to financing. In particular, senior debt holders are denied the security of knowing that they can expeditiously enforce their pnority over the assets of a debtor in the 38 Cervantes Ahumada, R Derecho de Quiebras, Editorial Herrero, S A, Tercera Edici6n, 1981, pg 261 39 Davalos Mejia, C, Titulos y Contratos de Credito, Quiebras, Harla, S A de C V, Primera Edic16n, pg 527 78 event of non-payment. The lack of an effective bankruptcy law is also partially responsible for Mexican industry's reliance on credit secured by real estate and financial leasing arrangements. 7.6 As a result of these deficiencies, creditors cannot count on the bankruptcy statute as an efficient mechanism for protecting their rights in a debtor's assets. Uncertainty over how different types of financial contracts will be treated in the event of the insolvency of one of the parties increases the costs of entering into such agreements. Debtors and their favored creditors can often exercise disproportionate power; such parties often reach agreements favoring the most important creditors and exert influence on less powerful lenders (typically supply creditors) to accept smaller payoffs. 7.7 Failed reform efforts. In recognition of the shortcomings of the existing law, the Ministry of Commerce and Industrial Development began work in 1994 on a draft law for the restructuring of debts of commercial companies. Although the draft was not circulated publicly, from newspaper reports it appears that one of its principal innovations was limiting the availability of suspension of payments for some commercial debtors, thereby hastening the process of liquidation.40 The potential for more expeditious liquidations would have strengthened the hand of lenders in negotiations with troubled borrowers. It is not surprising that a wave of public cnticism followed when copies of the draft law were apparently leaked to the press in early 1995, after the onset of the economic crisis. In the end, no proposal for bankruptcy reform was submitted to Congress by the Executive in 1995. 7.8 Recent developments. Notwithstanding their recognition that reforms in this area are crucial, SHCP and CNBV have been quite skittish about a real initiative. CNBV has conducted a seminar (financed by the FTAL) to bring its staff and the staff of SHCP up to speed on the problems of the current framework. Public statements in support of reform, however, have not been followed by discussion of the content of reforms. The government must initiate public dialogue regarding the essential nature of legal reform while focusing on presenting draft reform legislation to Congress and moving it through to adoption and implementation. Short-run recommendations 7.9 The judge's hand should be strengthened within bankruptcy proceedings. Judges must be given greater powers to make final decisions and order disposition of assets during proceedings. Of course, this can happen only if competent judges are appointed and they receive adequate training. In areas where there is caseload to justify it, bankruptcy cases should be handled by specialized courts. 7.10 The bankruptcy code should be amended to provide that bankruptcy proceedings take precedence over actions that cause interruptions and delays. The judge in a bankruptcy case needs to be able to stay actions under other laws, or resolve them within the context of the bankruptcy case. 7.11 The ability of creditors to bring criminal fraud charges against debtors should be constrained. These are often improperly used to intimidate parties and delay resolutions. 7.12 The bankruptcy law should be amended so that the initiation of bankruptcy proceedings does not interfere with the rights of secured creditors. Coordination with reform efforts in other areas of commercial law may also be important. 40 Reforma, May 25, 1995, page IA 79 7.13 Consultations should be held with NAFTA counterparties on ways to harmonize laws and cooperate procedurally in instances of cross-border bankruptcies. Long-run recommendations 7.14 An entirely new bankruptcy code should be developed with the assistance of a commission of jurists, business representatives, and academics, although only after a concerted judicial reform effort is under way. Companies Law and Minority Shareholders Rights 7 15 Mexico's laws governing corporations, partnerships, and other forms of business enterprise have not kept pace with the growing role of the private sector and the increasing importance of foreign direct investment (particularly from Canada and the United States). The available vehicles are not well-tailored to business realities, and legal practitioners too often disagree on their proper application, creating the potential for conflicts among investors and between enterpnses and third parties. In particular, there is general agreement among attorneys that the formalistic protections for minonty shareholders provided under current legislation do not discourage controlling parties from conducting the activities of the enterprise to their own advantage at the expense of the minority. The most common abuses appear to involve transactions with affiliates of the controlling shareholders, misleading and non-transparent accounting, and use of company guarantees for the benefit of the controlling shareholders. Naturally, these practices decrease the value of shares and discourage portfolio investment. Recommendations 7.16 The laws governing corporations should be simplified, with an emphasis on streamlining the formalities involved in routine corporate actions (such as capital increases) and establishing corporate forms appropriate for small, medium-scale and large (publicly held) enterpnses.41 The existing law of corporations imposes formalities (often involving shareholder votes and regulatory approval), that are often expensive in terms of attorney and notary time and registration fees. These may be particularly burdensome and unnecessary in the case of small and medium-scale enterprises. 7.17 The fiduciary duty of officers and directors to minonty shareholders should be clarified and provide for clear conflict of interest rules and procedures for independent director approval of transactions with affiliates of controlling shareholders. 7.18 Regulators' rulings on the laws governing corporations should be codified to eliminate uncertainty, encourage consistency, and extend the applicability of such rulings to entities that are not publicly traded. The inadequacy of the current body of law governing corporations is reflected in the number of questions of compliance that have been referred to regulators in recent years. In the case of large, publicly held companies, the CNBV has developed a body of formal and informal interpretations and a number of regulations covering vanous elements of the corporations law as applied to publicly traded companies. 7.19 A more modem limited partnership should be adopted permitting liability and accounting treatment similar to that accorded to Mexico's principal economic partners. Mexican lawyers, and their 41 ft seems to be the general view of the bar that minority shareholder rights are not sufficiently protected even in the case of large, publicly held companies and that this discourages portfolio investment. 80 domestic and international clients, have long bemoaned the lack of a well-developed legal entity that functions in a similar manner to the limited partnership (in which certain partners have general liability, while others are at risk only to the extent of their capital, and in which limited partnership interests are freely transferable). Limited partnerships are of particular importance in the area of joint ventures involving technology transfers.42 (Medium-size entities might also find it attractive as a method of achieving greater equity participation without diluting control.) The types of entities typically employed in place of a limited partnership continue to have serious shortcomings when compared with forms available under the laws of Mexico's NAFTA partners and certain European and convenience jurisdictions (such as the Channel Islands and some Caribbean countries): * Interests in a sociedad de responsabilidad limitada are not freely transferable. * The asociaci6n en participacidn is a contractual arrangement only, and does not create a legal entity with the capacity to sign contracts, bring suits, or be sued. * Other forms of business enterprise (such as the sociedad en comandita simple and the sociedad en comandita por acciones) are considered by some legal practitioners to be inadequate to modern business. The rights of participants and third parties are not sufficiently certain, because the applicable statute is insufficiently detailed and there is inadequate modern expenence (court decisions, consistent practice, regulatory rulings) with respect to such entities. * A thorough review should be made of the accounting treatment accorded to commercial companies, and inconsistent and uncertain treatment should be resolved. The accounting treatment of some types of companies is unclear under both Mexican law and the law of Mexico's principal foreign investors (particularly with respect to hybrid vehicles, such as asociaciones en participaci6n). This has lead to uncertainty with respect to tax treatment and inconsistent presentation in financial statements with the potential for misleading investors. There are publicly available prospectuses for Mexican companies that present completely different accounting treatment of investments in identical entities. The tax authorities of Mexico and of its principal trade and investment partners should be included in this process, and input from major international accounting firms should be sought as well. Secured Transactions 7.20 Mexico's system for pledging movable assets as collateral for loans and enforcing such pledges needs to be reformed to accommodate a broader set of permitted secured transactions at lower transactions costs. Until reforms are carried out, many Mexican businesses remain shut out from important sources of secured credit, including lending secured by equipment, inventories, and receivables. This has an especially detrimental effect on small and medium-size enterprises' which typically do not have the substantial unencumbered holdings of real property that serve as collateral for the overwhelming majority of secured loans in Mexico. 42 The limited partnership is often a preferred form of investment under the laws of Mexico's NAFTA partners, in part because its tax and accounting treatment is well-developed there. 81 7.21 Deficiencies of existing system. By all accounts, Mexico's current system is seriously deficient in important respects: * Laws in this area are fragmented among the banking and securities laws, the law of negotiable instruments, and the civil code. This has led to disagreements and uncertainty over the proper methods of pledging property in specific transactions. * As in most Latin Amencan countnes, the types of movable goods that may be the subject of an enforceable pledge without delivery of the goods to the secured party are limited to identifiable property. Floating liens and enforceable pledges of after-acquired property and proceeds are not available. * The public registries where security interests are recorded are generally in poor condition. Although the law governing pledges of commercial property is federal, the registries (outside the Federal District) are typically maintained (together with the civil registries) by state officials. Uniformity of operating practices is lacking. * Even where, as a legal matter, it is possible for a lender to have a valid security interest in movable goods, inefficient procedures for recovery of collateral, uncertainty about the priority of liens, and the necessity of recourse to the inefficient court system make lending secured by such property impractical except in exceptional circumstances. 7.22 In the absence of an efficient method of secunng a loan by a pledge of movable goods, the vast majority of lending by financial institutions to small and medium-size enterprises, as well as to larger companies, is secured by personal guarantees (which are of limited value), mortgages on real property, or both.43 Secured financing provided by manufacturers and dealers is rare.44 Lenders report that even in cases where loans are secured by movable goods, pledges of real property and personal guarantees are required. In contrast, in the United States approximately 30 percent to 40 percent of credit is secured by liens on movable goods alone.45 7.23 Recent developments. The World Bank, along with segments of the private bar, a number of non- bank financial institutions, industry representatives, and academic institutions, have advocated reforms to Mexico's commercial laws and improvement of its property registries to permit movable property (including receivables and inventories) to be more widely used as collateral for loans. This was highlighted as a major area for reform in the Bank's 1994 Legal System Policy Options Paper. The goal is to have a system for secunng loans with movable property that is reasonably consistent with the UCC-9 in the US and the PPSA in Canada. As demonstrated by a definitive study conducted by the National Law Center for Inter-American Free Trade, Mexican law in this area is seriously deficient when compared with that of its NAFTA partners. This places Mexican enterpnses, particularly small and medium-scale companies, as a comparative disadvantage in financing their activities. 43 The public registry of the Federal District, which has only 200,000 recorded interests in movable goods, is testament to the lack of an efficient system of secured credit 44 In countries with well-functioning laws on secured transactions, manufacturer and dealer credit (where the seller retains a security interest in goods sold to the next player in the chain of distribution) is usually an efficient source of short-term credit, since manufacturers and dealers are usually adept at assessing the value of the pledged equipment and the likely amount of time it will take before repossessed equipment can be sold 45 Although comparable statistics are unavailable for Mexico, interviews with bankers, suppliers, and borrowers indicate that much less than 5% of secured credit is secured by movable goods 82 Recommendations 7.24 A uniform law should be introduced governing secured transactions in movable goods. This would provide a more efficient legal framework for lending secured by equipment, inventory, receivables, and consumer goods. 7.25 The validity of floating liens on inventones and receivables should be explicitly provided for. 7.26 A uniform method should be provided for granting and recording pledges, irrespective of the nature of the collateral or the type of lender. 7.27 The new law should include procedures for granting, recording, and enforcing security interests that are as similar as possible to those under Article 9 of the Uniform Commercial Code (UCC) in the United States and the Personal Property Security Acts (PPSA) in Canada (given continuing financial system integration among Mexico, the United States, and Canada under NAFTA). 7.28 Policymakers should examine the successes and failures of options considered in other civil law countries (to the extent that certain legal concepts and procedures under the UCC and PPSA are inconsistent with Mexico's civil law system and traditions)--notably France and Spain, where deficiencies in the law of secured transactions have received significant attention. 7.29 The system of public registries should be made more efficient, permitting lenders to record pledges and providing them quick access to information about existing liens. Mexico's public registries need to become reliable repositories of records on secured transactions. Once lending secured by movable goods becomes more practical, lenders will need a rapid method to record pledges, and prospective lenders will need quick access to information about existing liens. It is critical to coordinate all efforts at improving Mexico's public registries with the process of reforming the laws on secured transactions. If not coordinated with law reform, efforts that are under consideration to improve the registries might be a waste of resources. 7.30 General agreement should be reached on how pledges of movable goods will be treated under the new law before developing and implementing procedures for the recording and retrieval of information in the registries. Otherwise, technology and procedures adopted by the registries as part of their contemplated renovation may not be appropriate under the revised law. 7.31 To the extent possible, the program for modernizing the recording of existing land titles should be carried out independently from efforts to improve the system for recording pledges of movable goods, so that improvements in the land title system are not delayed while a new law of secured transactions is being developed.46 7.32 State officials charged with maintaining the registries should be involved in the federal effort to reform the law on secured transactions. 46 More efficient procedures for recording interests in real estate, and improvements in the accuracy of existing records of land titles and mortgages, are critical to existing efforts to promote the development of title insurance and a secondary mortgage market in Mexico 83 7.33 A mechanism for expeditious recovery of collateral should be ihtroduced. Mexican lenders lack an efficient legal mechanism to recover collateral after a borrower defaults. In most cases secured lenders must bring suit and await the outcome of a full court proceeding before a judge authorizes recovery. This process is costly in terms of legal expense and, more important, time. Interviews with attorneys indicate that the process, which is ostensibly a summary proceeding, usually takes from six months to two years. Similarly, lenders expressed concern that collateral will devalue or vanish before the proceedings are concluded. By contrast, recovery within a week is typical for many industries in the United States. Weaknesses in Legal Enforcement 7.34 Legal reforms must be accompanied by reforms in Mexico's ineffective judicial system The 1998 CEM lists the following obstacles to better enforcement of contracts, especially in debt collection. * large overhang of cases; * poor quality ofjuges and judicial administration; * a populist bias against creditors, often reinforced by personal conflicts of interest; * complex and poorly drafted bank loan contracts; * the availability of lengthy appeal (amparo) procedures; * unwillingness of authorities at the state level to promote better judicial performance for fear of political or social consequences. 7.35 Several initiatives are underway to address enforcement issues. The Bankers Association has put in place an arbitration system for disputes among financial intermediaries. A project under preparation in collaboration with private rating agencies expects to set up a system to rate the effectiveness of the various state judges in enforcing contracts. The rating system is intended to apply pressure to reform state judiciaries. Recommendations 7.36 Programs can be instituted to improve the quality of judges. The system of judge selection, compensation and training should be reviewed. Deficiencies in training should be noted and a comprehensive program of judge training developed and implemented. 7.37 Legal reform should help in decreasing case backlog, but court procedures, in particular the appeals process, requires streamlining. 7.38 Finally, a public education program is necessary to inform the population as to why the clarification and protection of creditors' rights is in the interest of all people, since the it will result in the strengthening of the financial system. In the long run, the resulting growth in productivity that this would bring would mean more jobs and more access to banking and consumer credit for the population at large. Annex A Table A.1 Characteristics of selected grupos Company Major Organization and Veitical General cash-flow Intia-grupo Supplier Customer relationships activities and capital structure integiation management financing relationships businesses methods CIFRA Supermaikets, Retail stoles Low; CIFRA Administration & All businesses Small and micro Customeis use CIFRA testaurants, (including CIFRA- contiols only allocation of funds are cash suppliers qualify credit card foi small department mart,Vips, Sam's distribution centralized in producers; no for small business portion of purchases stores, and Clubs, Aurora, and retail holding; debt-free cross- funds from discount stores Bodega, Superama, company in which subsidization, NAFIN, which Wal-mart all subsidiaries nor inter- pays supplier for supercenters, generate sufficient company merchandise, and Suburbia); Recently cash to cover short- lending (not which is then reorganized: two term needs. Only needed); new repaid by CIFRA JVs with Wal-Mart one sub (Vips) is store openings, merged into franchised. branch CIFRA-mart; expansion, etc. Commercial financed via activities highly internal capital. decentralized Elektia Consumer Six subsidiaries Medium- Medium Limited cross- Cash paid to Grant credit to consumers electronics, organized under group includes centralization, subsidiary suppliers in 45 for most goods white goods, sub-holding retail, financial policies lending; days furniture, Diprofin; working personnel, allow companies to subsidiaries appliances capital financed by import, acquire loans, usu. have control credit lines from financial, with parent over own Mexican banks, manufacturing guarantee; dividends finances primary and , and retail from profits secondary issues of companies/ upstreamed to paper, and foreign holding issuance of bonds 86 CARSO Diveisified subsidiaries Medium to Subsidiaries run Inter- holding, grouped undei high in basic independently, subsidiary including several sub- manufacturing allowed acquire lending tobacco, holdings, capital activities, e.g., debt; limited mining, retail, structuies vaiy copper. guarantees by vulcanized across sub- holding or sub- rubber, non- holdings holding to ferious metals companies Bimbo Foodstuffs, Subsidiaries in Medium Subsidiaiies do not No intei-sub Small supplieis confectionery, U.S., Mexico and packaging and borrow lending, but program involved snack foods L America; all debt distribution independently; holding will consolidation of is dollar-based; integrated single company use excess cash small holders into most products within the manages treasuries generated in faiiiing (potato, generate cash conglomerate. of all subsidiaiies richer corn, cocoa) sufficient to cover and holding companies to associations working capital subsidize needs (>80% of poorer total sales in cash) Hermes Steam-based Diversified group Low Subsidiaries manage Limited cross- Most suppheis aie Main purchaser of auto energy, auto with five business all finances subsidiary foreign parts is GM, which parts, transport units; strategy of independently; some lending, but companies, paid purchases parts on similar activities, car holding to acquire loans are guaranteed holdimg (which after 45-60 days float dealerships, businesses, find by parent also borrows) powei foreign partner, sell will lend to generation subsidiaries CEMEX Cement Activities divided High: Mexican subsidiaries Cross- Limited supplieis Half of production is sold between Spanish backward receive holding company credits; most as cement bags to and Mexican integration guarantees for loans, lending and cement suppliers construction companies-- subsidiaries into mining Spanish division cross (mines) have been limited credit and minerals companies do not; subsidization; acquired; othei coking dividends revolving major suppliers upstieamed to credit facility are PEMEX and holding; financial set up by CFE decisions tend to be holding centiahzed ("iainy-day" _I find) 87 Gruma Packaged Four main Low Highly centialized No cross Suppliers' credit Main sales to foodstuffs subsidiaries under financial lending; cross- programs through supermarkets, given 30 holding; controls management subsidization NAFIN, days to pay, othei sales to >70% of corn flour does occur Bamcomext, and tortilla producers, who aie market; Banxico: NAFIN not requiied to pay until participation by giants credit to next order. ADM in another small produceis, subsidiary Bancomext and Banxico guarantee 90% of funds from commercial banks to corn growers IMSA Specialized Large steel and Medium to Financial operations Limited cross- None Credits granted against steel, car metal products high: controls are moderately subsidization; promise of future batteries, producer; has steel decentralized; holding may puichases construction issued 50% of manufacturing subsidiaries are give capital metal equity on Bolsa and from coking permitted to take on infusions to NYSE; all debt to rolling debt; decisions are subsidiary in denominated in mills, but made at the holding emergencies; US$ purchases level all subsidiaies slabs; battery hold certain making also deposits of vertically cash at the integrated holding level, which may be lend out to subsidiaries 88 Pulsar Diversified Medium to Decentialized- Only holding- group covering high, esp. in subsidiaries have to-subsidiary tobacco, agio- cigaiette lines of credit to loans on short- chemicals, bio- business, Mexican banks, term basis; tech which controls manage own debt emergency manufacturing and insuiance funds do exist, , packaging, coverage but intent of and management is distibution to ensure subsidiary independence Vitro Glass products, Five business Medium to Decentralized: No cioss- Have long-term appliances, "centers" each high- subsidiaries borrow subsidization, agreement with special owned 51-100% by company has (with holding but holding Unimin household holding recently, guarantees); asset- may capitalize synthetic however, sold less financing loss-making materials mineral mines vehicle has bee subsidiaries; created to issue inter-company paper in foreign lending markets; debt all prevalent. peso-denominated Alfa Petrochemicals Large, highly More forward Highly decentralized No cross- Upstream is state- , specialized diversified integration financing; subsidization owned (PEMEX, steel, food industrial group, into finished independent oi cioss CFE) processing, 75-80 subsidiaries products and subsidiary lending lending; telecoms grouped under distribution, (without guarantees); occasional sub- several upstream is banks have longer- holding to subholdings; most largely state- term relationships subsidiary debt is dollar owned with operating lending denominated subsidiaries CYSDA Chemicals, Four business Highly Financially Holding lends Upstieam is state- None fibers and groupings, 20 vertically centralized, being money to owned textiles, companies integrated, further centralized; subsidiaries, flexible especially in no independent loan noi cioss- packaging, textiles and taking lending oi envionmental chemicals cioss- sei vices subsidizations ANNEX B NAFIN and BANCOMEXT activities. B. I In the following pages, the roles of NAFIN and BANCOMEXT as viable lending alternatives to Mexican enterprise are discussed NAFIN B.2 Nacional Financiera, S.N.C. (NAFIN) provides mainly financial services to foster enterprise sector development, particularly the growth of industrial enterprises. It plays the role of financial agent to administer loans provided by bilateral and multilateral agencies to government agencies and provides financing to both public and private enterprises. While it finances both public and private enterprises directly, financing to the private sector is channeled mainly through financial intermediaries (banks and non-bank institutions). In 1996, NAFIN served more than 11,300 private enterprises, of which approximately 95 percent were micro- or small enterprises (i.e., enterprises with less than 100 employees and with annual sales of up to 2 million pesos). B.3 NAFIN's primary financial products for private enterprises include the provision of credit, credit guarantees and risk capital. It also provides a limited amount of technical assistance to enterprises and non-banking institutions in areas such as project preparation and project evaluation. B.4 Trends in NAFIN financing. The economic crisis which began in 1995 led to an overall decline in commercial bank lending across all sectors. As a result, and in spite of funding availability, credit provided by NAFIN through commercial banks decreased substantially. Total credit provided by NAFIN to the private sector, which amounted to the equivalent of US$12.6 billion in 1993 and to US$10.4 billion in 1994, dropped sharply to approximately US$1.7, and US$1.9 billion in 1995 and 1996, respectively. This decline continued in 1997, as total NAFIN lending to the private sector reached only about US$0.8 billion during the first eight months of the year. Furthermore, as indicated in Figure B.1, the decline in lending since 1993 has been felt most heavily by micro- and small enterprises. While in 1993-1994, micro and small enterprises absorbed over 65 percent of funding, from 1995 onwards they have absorbed less than 20 percent, as a result of the reduction in bank lending and the banks' practice of focusing in restructuring loans of larger borrowers; 91 Fig. B.1: NAFIN Credit Lending Volume 1993-1997 14,000 12,000 10,000 -'000,000 USD 8,000 6,000 4,000 2,000 1993 1994 1995 1996 1997 Year Large - Medium a Micro/Small B.5 The effect on micro- and small enterprises can be seen in the sheer numbers of firms which no longer receive NAFIN financing. As indicated in Figure B.2, during 1993 and 1994, for example, NAFIN served an average of about 130,000 enterprises. This number dropped to 37,000 in 1995 and to 11,400 in 1996; by August, 1997, as few as 4,400 enterprises were being served. B.6 Furthermore, although NAFIN lending had traditionally been concentrated in manufacturing, starting in 1995 the share of manufacturing in total NAFIN credit almost doubled, increasing from about 38 percent in 1993-94 to over 72 percent in 1995 and to 82 percent in 1996. This change reflects the high level of credit restructuring which has taken place in that sector. A substantial portion of NAFIN financing -- about 30 percent in 1995 and to approximately 43 percent in 1996 -- has been associated with credit restructunngs. 92 Fig. B.2: NAFIN Credit number of firms 1993 - 1997 140,000 120,000 - 100,000 80,000 60,000 40,000 20,000 1993 1994 1995 1996 1997 Year B.7 Although most NAFIN lending through intermediaries has traditionally been distributed through commercial banks, a portion of NAFIN funds has also made available through non-bank institutions such as credit unions, and leasing and factoring companies. Due to the financial difficulties encountered by these institutions during Mexico's financial crisis, the portion of NAFIN funds placed by non-bank financial institutions decreased from 28 percent in 1994, to 14 percent in 1995 and to 9.7 percent in 1996 It is expected that this share will decrease even further during 1997. B.8 NAFINprograms to finance the private sector. Since 1995, NAFIN has entered into a process of redesigning the various programs supporting the private sector, particularly SMEs. The three primary credit programs that existed in 1995 to finance enterprise modernization, restructuring of liabilities, and general support for micro-, small and medium-size enterprise have since been integrated into a single program known as the Programa Onico de Financiamiento a la Modernizaci6n Industrial (PROMIN). Out of MP$15 billion channeled to the private sector in 1996, about MP$12.7 billion (85 percent) were allocated through PROMIN. B.9 In a further effort to simplify the programs channeled through intermediaries to finance private enterprises, in August 1997, NAFIN integrated all existing programs (including PROMIN) into the Programa de Operaciones de Segundo Piso. A significant feature of this program is that large enterprises are also eligible provided they have strong production backwards linkages. Financing is provided both in local and foreign currency. Resources allocated for this program to be committed during 1997 amounted to MP$21.9 billion. As of August 30, only MP$6 billion have been committed, reflecting once again the continuous drop of commercial bank lending. This reflects not so much the lack of funding but the focus of banks on operational restructuring, collection of loans and in general a new-found cautious approach to new lending. B.10 A second window of NAFIN financing is provided by its direct, or first-tier, lending. These lending activities are intended to ensure access to long-term financing by enterprises during the current period of limited commercial bank financing. As a result of direct lending under this program and the concurrent substantial decline in credit granted through commercial banks, as set forth in Figure B.3, first-tier lending increased from an average of approximately 1.3 percent of NAFIN total credit to private enterprises in 1993 and 1994 to approximately 12 percent in 1995 and 1996, although it has fallen to only 4.0 percent for the first eight months of 1997. Indicative of all NAFIN enterprise lending during this period, however, first-tier lending has been concentrated in a few creditworthy large enterprises, as many 93 other enterprises have not met NAFIN's credit assessment approvals as applied under the new economic conditions or have simply tried to avoid further indebtedness under a vulnerable financial environment. Given this concentration, as of August 30, 1997, only MX$0.25 billion of the MX$3.2 billion allocated for this program was committed. Fig. B.3: NAFIN Credit by Tier '0,0,000 USD 1993-1997 14000 12000 10000 8000 6000 4000 2000 0 1 I9 I 1993 1994 1995 1996 1997 Year Et First Tier = Second Tier B. 11 In addition, in early 1997, NAFIN introduced its Suppliers Development Program ("Program de Desarrollo de Proveedores"), aimed at promoting the development of a network of competitive and efficient suppliers to large enterprises. The program is meant to address the issues of ensuring product quality standardization, timely supply and competitive prices to be furnished to large, Mexican enterprises. For this purpose, NAFIN provide eligible SMEs with technical assistance and financing. Technical assistance focus mostly in achieving product quality standards, and their timely delivery. Financing is provided by NAFIN through both its second-tier program, channeling funds through commercial banks,47 or directly through its first tier-window. As of the end of November 1997, almost half of the US$260 million allocated to this program have been committed, supporting the operations of close to 800 small and medium-size enterprises. B.12 NAFIN equity financing. During 1995, NAFIN began to implement a MP$5.0 billion program to provide equity to small- and medium-scale firms, with a view to assisting enterprises in debt restructuring and accessing financing during the tight credit environment that existed. Under that scheme, a creditor bank would convert enterprise debt to equity ownership, and NAFIN would take an equity position of equal value, subject to the condition that the sum of the bank's and NAFIN's ownership would not exceeding 49 percent. To ensure that this assistance was temporary, the enterprise was supposed to purchase NAFIN's shares within five years, or this ownership position would be increased to 51 percent. B.13 The results of the program, however, were highly disappointing. NAFIN estimated that 400 to 500 firms could have been covered by the program dunng its first year, assuming an average equity 47 NAFIN has also begun, on a very limited basis, to channel loan funds, on a second-tier basis, through the large enterpnses which benefit from the small suppliers' production. This is discussed more fully in Chapter VI. 94 contribution of MP$10 to 15 million per enterprise. Instead, only three projects were approved (out of 76 applications), for a total amount of P$85 million. Lack of interest of commercial banks in the scheme, including their reluctance to convert debt into equity of enterprises at a time of financial uncertainty, when banks were focused on reducing their financial exposure to enterprises, have been quoted as the main reasons for the failure of the program. The program was canceled in May 1997, and the earmarked funds were integrated into NAFIN's more traditional equity investment programs. B.14 NAFIN has also invested approximately US$50 million in its own SINCA, a venture capital-type fund which it manages through a subsidiary. This fund invests from USD$ 5 to 20 million in each company, expecting to hold its shares for two to three years. The fund invests in a minority position and according to fund officials, enterprise owners are comfortable with NAFIN's position in their companies because they know the investment is temporary and does not threaten their control NAFIN also maintains minority participations in other SINCAs. By the end of 1996, NAFIN was invested in a total of 33 such funds, representing a total investment of MP$ 139 million. B.15 NAFINguarantees NAFIN's guarantee schemes are intended to facilitate the accessing by small and medium-size enterprises to commercial bank financing. Given the stagnation in bank credit operations, however, the guarantee program has been ineffective. Although 16 banks have signed agreements with NAFIN under which NAFIN would guarantee loan repayments, the guarantees have been used with respect to only 40 credits amounting to only MP$12.6 million. BANCOMEXT B.16 The Banco Nacional de Comercio Exterior, S.N.C. (BANCOMEXT) provides financial and non- financial services to foster exports and foreign direct investment. In 1996, BANCOMEXT served more than 50,000 customers at its 38 offices in Mexico. BANCOMEXT has overseas representative offices in its major trading partners that identify and promote opportunities for Mexican exporters. B.17 BANCOMEXT's financial products include pre-export and export sales credit, investment credit, import credit, and financial consolidation credit for exporters; guarantees, risk capital, buyer credit, letters of credit, investment banking, fiduciary services, and foreign exchange operations. Its non-financial services include overseas promotion (e.g., trade fairs), market information, technical assistance and advisory services, training, and development programs for domestic suppliers of exporters. B.18 Trends in BANCOMEXTfinancing. BANCOMEXT provides export-related credit to the productive sector both as a first-tier institution (lending directly to enterprises) and as a second tier (lending through commercial banks and other financial institutions including development banks, factoring and leasing companies, and credit unions). Before the 1995-96 economic crisis, the majority of BANCOMEXT credit was second-tier financing--84 percent in 1993 and 79 percent in 1994 (see Figure B 4 and Table B.1). Credit volume averaged US$13.3 billion per year in 1993-94, and served about 6200 firms per year. B.19 The economic crisis led to a general decline in commercial bank lending to the productive sector, and export-related credit rediscounted by BANCOMEXT followed the same pattern. BANCOMEXT's second-tier lending declined from US$10.3 billion in 1994 to US$6.0 billion in 1995 and US$4.9 billion in 1996. To fill the gap in financing of the real sector during the crisis (and presumably to maintain income on credit operations), BANCOMEXT attempted to increase its first-tier lending. However, while the share of first-tier lending increased somewhat (from about 19 percent in 1993-94 to 23 percent in 1995-96), the volume of BANCOMEXT direct lending has continued to fall. 95 B.20 Based on volumes durng the first eight months of the year, 1997 second-tier lending is estimated to fall further to US$2.3 billion. BANCOMEXT officials explain the further decline in second-tier lending as the result of large commercial banks having access to funds from other sources at competitive interest rates, and the general situation of liquidity in the commercial banking sector. In addition, BANCOMEXT has lost some of its largest first-tier clients to foreign banks. B.21 As Figure B.4 shows, as a consequence of the dramatic decline in second-tier credit combined with a moderate decline in direct lending, total BANCOMEXT credit is now only about one-quarter of its pre-crisis level. Fig. B.4: Bancomext First and Second Tier Credit '000,000 USD 1993-1997 11000- 12000- - 10000- 4000--IM 2000- 40- IW I I 1993 1994 1995 1996 1997(est.) Year First tier 3 Second tier Note. 1995 and 1996 total volume includes guarantees. Source BANCOMEXT. 96 NAFIN CREDIT STATISITICS Table B.1 NAFIN Credit Lending Volume Millions of Pesos 1993 1994 1995 1996 1997* Micro/Small 26,243.0 35,681.0 2,375.4 2,761.5 1,637.7 Medium 2,116.0 4,347.0 1,299.4 1,659.0 9307 Large 10,680.0 13,225.0 9,372.8 10,852.1 3,750.6 Lending Volume 39,039.0 53,253.0 13,047.6 15,272.6 6,319.0 NAFIN Credit By Tier Millions of Pesos 1993 1994 1995 1996 1997* First Tier 707.6 350.7 1,444.0 1,892.5 253.0 Second Tier 38,331.4 52,902.3 11,604.6 13,380.1 6,066.0 Total Credit 39,039.0 53,253.0 13,047.6 15,272.6 6,319.0 NAFIN Credit Lending Volume Millions of USD 1993 1994 1995 1996 1997* Micro/Small 8,446.41 6,928.35 308.89 350.00 211.19 Medium 681.04 844.07 168.97 210.26 120.01 Large 3,437.40 2,567.96 1,218.83 1,375.42 483.64 Lending Volume 12,564.85 10,340.39 1,696.69 1,935.69 814.85 NAFIN Credit By Tier Millions of USD 1993 1994 1995 1996 1997* First Tier 227.74 68.09 187.77 239.86 32.62 Second Tier 12,337.11 10,272.29 1,509.05 1,695.83 782.22 Total Credit 12,564.85 10,340.39 1,696.69 1,935.69 814.85 * data as ofAugust 1997 1 98 ANNEX C COMPANIES LISTED THROUGH THE MMEX MARKET Market Sector/Company (Share Class) Capitalization US$ million as @ Sept. 30, 1997 Chemicals & Petrochemicals Dermet (A,B) 27 123 Food, Beverages & Tobacco Agro Industrial Exportadora (A) 9.939 Pastelena Francesa (El Globo) 75.804 Gmacma (B,L) 23 425 Grupo Nutnsa 13 452 Rubber & Plastics Convertidora Industrial (A,B) 16.583 Manufacturing Dixon 14.488 Construction Grupo Iconsa (A,L) 16.200 Grupo Profesional, Planeacion y Proyectos (A,B,B 1) 36.232 Commerce Dataflex (B) 183.625 Ferrioni (A) 15.023 Fotoluz (B,A1) 412 Gomo 81.571 GPQ (B) 22.580 Madisa (A,B,L) 32.503 Communication and Transportation Biper 214.775 Services Cidmega (A,B) 68.470 Medica (A,B,L) 69.449 Total 921.114 99 COMPANIES RECLASSIFIED INTO THE MMEX MARKET Market Sector/Company (Share Class) Capitalization US$ million as @ Sept 30, 1997 Chemicals and Petrochemicals Oxy 1.375 QB Industrias (A,B) 8 079 Regio Empresas (A) 15.610 Prntmg, Editonal & al Diana (A,B) 10.806 Electncals-Electromcs IEM (A,B) 15.676 Q Tel (B) 0.663 Transportation, Machmery & Equipment A C Mexicana (A1,Bl) 0.321 Food, Beverages & Tobacco Campus (A,B) 6.479 Textile, Apparel & Leather Geasa (1,2) 5.586 Construction Lamosa (B) 83.633 Commerce Almaco (1,2) 215.635 Services Aristos (A,B) 90.027 Brokerage Casa de Bolsa Arka (A,B) 17.070 Insurance Companies Alianza (CP) 34.080 Laseg 15.365 Patna 11.663 Credit Institutions Cafsa 6.620 Fiatlas 4.214 Lotonal 3.878 Venture Capital Unica (A,B) 2.877 Total 549.665 Total MMEX Market Capitalisation 1,470.769 ANNEX D Use of Proceeds of IPOs/POs during 1997 Company Use of proceeds Grupo Provequim Investment for growth Ece Debt repayment and construction and redecoration of restaurants Grupo Minsa Debt repayment, working capital and investments Grupo Fin. Invermexico Sale of founders shares Pasteleria Francesca Geographic diversification Consorcio Hogar Investments in new projects, purchase of land Corp. Mex. De Rest. Opening of 20 new restaurants Corporacion GEO Investments in new projects, purchase of land Biper Geographic diversification G. Accion Debt repayment, working capital and investments DataCapital Debt repayment G.Collado Debt repayment Gruppo Covarra Expansion of production capacity and opening of "fashion caf" restaurants Fondo de Optimi. De Sale of founders stock Cap. TV Azteca Sale of founders stock plus investment in transmission and production equipment Grupo Comercial Gomo Working capital for expansion of distribution channels, plus purchase of equipment Corporacion Moctezuma Sale of founders stock Industrias Bachoco Investment for growth Grupo Industrial Saitillo Investment in two subsidiaries Grupe Debt repayment and construction of a 9 holes golf course Grupo Azucarero Mexico Debt repayment Corporativo Fragua Investment in two subsidiaries ANNEX E OBSTACLES TO THE DEVELOPMENT OF ASSET-BACKED SECURITIES IN MEXICO In addition to the hurdles that Elektra faced (see Box, Chapter 6), there are additional challenges to securitizing peso-denominated assets which may be grouped as follows: issues relating to standardization and quality of the assets; problems with transfernng assets to the entity which issues the securities; shortcomings of the para-financial services infrastructure required for assessing the quality of secuntized assets; legal/regulatory limitations on the types of securities which may be issued, capital adequacy rules for credit institutions which hold or provide enhancement for asset-backed securities; and tax treatment of asset-backed transactions. Standards and Quality of Assets The first requirement of asset-backed securities is the origination of relatively homogeneous underlying assets whose characteristics and quality are amenable to evaluation. The types of assets generally considered candidates for secuntization in Mexico (mortgage loans, consumer credits, receivables, commercial loans, etc.) have typically suffered from both lack of standardization and low origination standards that complicate asset evaluation. Reliable information about the initial condition of lenders and collateral is often unavailable. (See the discussion of credit bureaus and appraisers, below.) Documentation of similar loans made by a single lending institution is often less than uniform, raising issues of legal risk. Finally, servicing of loans by a single institution often varies significantly from one branch office to the next. Systems for monitoring important information (timeliness of payment, balance, address), data processing and software, and enforcement critena (such as how many missed payments will result in repossession efforts) remain quite variable. More intensified efforts to address the issues of standards and asset quality could conceivably come from one or more of the following sources: large individual financial or non-financial entities taking the lead with an eye toward gaining a financing cost advantage; industry association initiatives; government second-tier or guarantee programs; and truth in lending laws. There has already been efforts by Mexico's largest banks to standardize their mortgage documentation, origination standards and servicing policies. Mexico's newly-established limited-purpose banks (SOFOLs) have begun discussions among themselves on standards which might one day permit them to secuntize assets of more than one originator through a single pool. FOVI loan programs for low and medium-income borrowers, through which a Banco de Mexico trust provides second-tier lending to commercial banks, requires standard documents and performance monitoring (but provides no servicing guidelines). Industry association initiatives and government truth in lending initiatives, which might require loan documentation to be presented to consumers in a common (and easily comparable) format would accelerate standardization, in addition to serving a consumer protection objective. Transfer of Assets to Special Purpose Entity The transfer of all the legal rights and priorities of the originator of an asset to a special purpose entity (SPV trust or corporation) is critical to the issuance of asset-backed securities for two reasons: transfer to the SPV isolates investors in the securities from risk of failure of the originator; and transfer (as opposed to a pledge) permits the originator to remove the asset from its balance sheet. The later is of 102 particular importance to banks and other financial entities which are subject to capital and provisioning requirements. Under Mexican 1aw, transfer of assets represented by negotiable instruments (consumer loans, car loans, trade receivables) is relatively expedient and inexpensive. Transfer of a negotiable instrument is governed by the Federal Negotiable Instruments Law which merely requires endorsement and delivery of the instrument to the transferee. However, the transfer of a mortgage instrument is governed under the Civil Code of the state (or the Federal District) in which the property is located. These state Civil Codes generally require the borrower receive notice and for the transfer to be notarized and recorded in the public registry of property where the property is located. Notarization of a mortgage transfer in Mexico is an expensive and time-consuming process wherein a public notary (an attorney specially licensed under state law) executes a public deed in accordance with the same complicated formalities required upon original sale of the property. According to a government study, the average notary fee in the Federal District in connection with such a sale is approximately 8% of the purchase price. The notary is required to venfy the payment of applicable taxes and the absence of pre-existing liens. Registration in the public registry of property can also be a drawn out process lasting several months (the average is four in the Federal District) and requiring the payment of substantial fees (approximately US$400 in the Federal District). Each state maintains its own registries and often regards registry fees as an important source of revenue.48 Recent reforms to the Civil Code of a few states and the Federal District now permit the transfer of mortgages (usually only in connection with a secuntization) without notarization or registration, or even notice to the debtor where the servicing of the mortgage remains in the hands of the originator. However, even in these jurisdictions, is it unclear that the transferee is entitled to all the rights and priorities of the originator. Another solution recently proposed is to create a clearinghouse for mortgage instruments. Under this scheme, a new mortgage would be registered in the name of the clearinghouse, which would issue a participation certificate (in the form of a negotiable instrument) to the originator. The originator could then freely transfer the certificate to a purchaser, including a SPV issuing mortgage-backed securities. Mexican commercial banks (but not limited-purpose banks (SOFOLs)) face additional complications when transfernng mortgage as well as non-mortgage loans. Mexican banking law provides that a Mexican commercial bank may not transfer an interest in a loan to a non-bank (including an SPV) without the authorization,of the Banco de Mexico.49 The conditions under which the Banco de Mexico will permit such transfers have been the subject of discussions between the Banco de Mexico and the banks for a number of years. The Banco de Mexico has indicated that it will permit a bank to transfer a loan off its balance sheet only if it is sold completely without recourse. In the event that the bank retains 48 Mexican notary and registry costs are high by industrial country standards and are an impediment themselves to housing finance. The government should take steps to reduce notarization requirements, encourage competition and modernize registries. The recent introduction of corredores pzbhcos has brought notarial costs down in the commercial context. Other civil law countries have undertaken successful notarial system reforms. 49 Another obstacle to secuntization of bank-onginated assets had been bank secrecy rules that prohibited banks from divulging information on their debtors. This obstacle was removed by legislation approved by Congress in April 1996 which permits the sharing of such information with potential purchasers of assets and in connection with their possible secuntization. 103 recourse or buys back from the SPV a subordinated interest in the securitization, the Banco de Mexico has indicated that it will require the capital to be maintained (which is appropriate), but has yet to issue clear regulations of general application governing the calculation of such required capital. (See below.) Servicing Infrastructure Although the situation is improving, the availability and quality of para-financial services essential to a well functioning asset-backed securities market in Mexico still remains inadequate. Improvements are needed in the areas of credit bureaus, appraisers, rating agencies, title and mortgage insurance and trust services. Credit Bureaus Two issues are involved in assessing the value of the underlying obligations in a secuntization. the credit quality of the borrower and the value of any collateral pledged to secure the borrower's obligation. In order to adequately assess the borrower creditworthiness, the loan onginator needs to have ready access to reliable credit histories. In the context of asset-backed lending, it is important that purchasers be able to confirm that the obligors on the underlying assets have met appropriate creditworthiness standards. Until 1995, the only centralized sources of credit information on individuals and companies were maintained by Banco de Mexico for the exclusive use of commercial banks. Banks pooled information only on defaults. Performance of financial obligations to other types of entities (leasing companies, retail credit departments, suppliers, etc.) was not monitored. In February 1995 new regulations were issued authorizing the establishment of pnvate credit bureaus to maintain comprehensive credit histones of borrowers. Three new bureaus began operations during the course of that year. Although the preexisting credit bureau owned by the Mexican commercial banks has agreed to share information on defaults with the start-ups, banks continue to regard as proprietary records on timely payments. This lack of access to "good news" on debtors limits prevents credit bureaus so far from supplying customers with the full credit picture of a potential borrower. Appraisers Where the instruments underlying a security (such as mortgages, equipment loans and the like) are guaranteed by identifiable property, the originator needs to have reliable valuations of such collateral. Unfortunately, appraisal standards in Mexico remain very loose. There are over a dozen associations of appraisers, each with different standards, licensing requirements and levels of supervision. Real estate appraisers often work exclusively for a single client (usually a major bank), which compromises the independence of their assessment. In addition, there is little reliable current public information on real property values upon which to base an objective appraisal (comparables). The sales prices reported to public property registries is often manipulated to avoid taxation. Turn-over in housing in Mexico is much less than in most industrialized countries, resulting in fewer comparable sales. FOVI is attempting to increase the information available on home prices by developing a nation-wide database of home prices.50 50 Title insurance in Mexico is almost non-existent for residential property As discussed above, the property registries in Mexico are administered on a state-by-state basis and often are sorely in need of modernization Many residential area suffer from clouds on title, which may include poor surveys, incomplete government efforts to regularize titles and possible ejido claims. Although ready availability of title insurance is not a prerequisite to the development of mortgage-backed secunties, it may prove a useful tool for enhancing the quality of the mortgages originated by institutions operating m areas where title problems are of special concern (such as the pen-urban market). 104 Trust Services Most special purpose entities for the issuance of asset-backed secunties are organized as limited- purpose trusts or corporations. . In order for investors to have confidence that the underlying assets will be applied to the payment of the asset-backed securities in accordance with their terms, the special purpose vehicle must be legally independent and its trustee or officers required to act only in accordance with pre-established rules (such as those relating to priority of payment). For legal and tax reasons too complicated to address here, the trust appears to be likely to remain the preferred choice in Mexico. Mexico is singular among Latin American countries in having a long-standing and well- developed body of law governing the organization and operation of a trust (fideicomiso). The trust as a legal concept has existed in Mexico for over a century, is well understood by the legal community and familiar to the public at large. However, under Mexican law only bank trust departments and brokerage firms (in the case of securities trusts) may serve as trustees. Competition is accordingly quite limited and fees remain high. Most trusts currently administered by Mexican banks are land and other passive trusts that do not require the trustee to do much more than hold title documents and keep accurate financial records. Decision making is usually left to a technical committee composed of representatives of the persons who established the trust. In those cases where trust departments have been required to act independently on the basis of pre-established rules, the experience has been disappointing. Limitations on the Types of Securities Issuable by a Trust As noted above, the trust is likely to remain the preferred vehicle for Mexican securitizations. Although in most respects trust law is well developed in Mexico, there are no clear guidelines for the issuance by a trust of true debt instruments. The Banking and Securities Commission has authorized the issuance by trusts of certain sui generus debt instruments, but general and flexible rules for the issuance of the variety of debt securities typically issued in asset-backed deals exist only for corporations. Accordingly, most transactions to date, including the Credibure and Toluca Toll Road issuances, have relied on the issuance of trust certificates rather than debt obligations. Most legal practitioners believe that for most purposes an ordinary participation certificate (certificado departiczpaci6n ordinaria, or CPO), which is issuable by a trust, can be made to work like a debt security. However, the mechamcs for issuance of CPOs are complicated, requiring notarization through a deed of trust, approval by the Banking and Securities Commission and appraisal of the interests by a national development banks. In addition, as a legal matter, the holder of a CPO is entitled, like an equity holder, to an undivided interest in the trust rather than the payment of a sum certain and interest as in a typical debt security. This creates two complications that experience has shown can be mitigated but not entirely eliminated. The first is that it is difficult to create tiered structures of pass-through and pay- through instruments, comparable to the issuance of various classes of senior and subordinated debt and equity of a corporation. Secondly, the structures that are possible are quite complicated, difficult to explain to investors and sufficiently different from what investors are accustomed to that marketability has been adversely affected. Capital Adequacy Issues Capital adequacy issues arise in connection with credit enhancement provided by deposit-taking and other institutions required to maintain adequate capital to provide a cushion against risks. Credit enhancement is typically necessary in order to secure an investment grade rating for the publicly issued 105 securities. It typically takes the form of either a senior/subordinated debt structure or the provision by a financial institution of some form of limited guarantee, reserve account or letter of credit. In the case of senior/subordinated structures, the capital adequacy rules would also apply in the case of a financial institution (such as an insurance company) purchasing a subordinated secunty from the originator of the transaction. Mexican banks are generally required to maintain capital equal to 8% of risk-weighted assets Thus far, the Mexican financial authorities have not issued clear rules governing how banks should treat subordinated obligations they retain as part of senior subordinated securitization structures. They are even further away from clarifying the treatment of guarantees, reserve accounts or letters of credit. In the context of certain transactions involving interests in pools of Mexican government securities, the Banco de Mexico has required banks to maintain capital equal to 100% of the face value of the subordinated securities. This rule applied to senior/subordinated structures involving securitizations of bank-onginated assets such as mortgage loans and consumer credits would probably make such transactions unappealing to banks. Tax Issues Because asset-backed security schemes involve the transfer of assets, the interposition of a special purpose vehicle and the redirection of financial flows they may result in undesirable tax consequences. In order to present an attractive alternative to convention finance, securitization must not result in a significant increase in the overall tax burden. Structuring an asset-backed transactions requires examination of the potential tax effects for the originator of the assets, the obligors under the assets, the special purpose entity issuing the securities and the investors in such securities. Issues and uncertainties too numerous to address here have arisen in the context of taxation of Mexican asset-backed securities. In particular, the applicable tax rules differ, depending on the type of asset, whether the onginator is or is not a bank, and whether a trust or corporation is chosen as the type of special purpose vehicle. Fortunately, the tax treatment of residential mortgages is pretty straightforward. Interest payments by the homeowner are exempt from value added tax regardless of whether the payments are made to the originating bank or a special purpose vehicle s Credit card interest is always subject to value added taxation, regardless of to whom it is paid. However, in the case of commercial loans and certain other obligations, interest is exempt from value added tax only so long as the obligee is a bank. Thus, a transfer of the asset to a special purpose entity in connection with a securitization would result in increased taxes for the obligor. This and other tax issued will need to be addressed before market actors will be able to undertake certain types of transactions. si In Mexico mortgage interest is not deductible from personal income taxes. 107 REFERENCES Caprio, Gerard Jr. and Ash Demirguc-Kunt, 1997, "The Role of Long-term Finance. Theory and Evidence," Policy Research Working Paper #1746 Cooper, Wendy, "The Struggle to Save Nordic Banking", Institutional Investor, August 1993, pages 63 - 66. 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