Mexico - Second Contractual Savings Development Program (CSDP 02)

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 19676 IMPLEMENTATION COMPLETION REPORT MEXICO SECOND CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM (CSDP II) Loan No. 4343-ME December 22, 1999 Finance, Private Sector & Infrastructure (FPSI) Country Management Unit 1 Latin America and Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUI VALENTS Currency Unit = Peso (P) US$1.00 = P $9.5 (June 1999) FISCAL YEAR January I - December 31 ABBREVIA TIONS AND ACRONYMS AFP Adninistradoras de FondQ de Pensiones (Pension Fund Administrator - Chile) AFORE Administradora de Fondos para el Retiro (Pension Fund Administrator --Mexico) AMAFORE Asociacion Mexicana de Administradoras de Fondospara el Retiro (Mexican Association of Pension Funds Administrators) BANOBRAS Banco Nacional de Obrasy Servicios Pziblicos, S.N. C. (National Bank of Public Works and Services) CNBV Comisi6n Nacional Bancariay de Valores (National Banking and Securities Commission) CONSAR Comisisn Nacional del Sistema de Ahorropara el Retiro (National Commission of the Retirement: Savings System) FOBAPROA Fondo Bancario de Proteccion al Ahorr, (Bank Fund for Savings Protection) FOVI Fondo de Operacion y Financiamiento Bancario a la Vivienda (Housing Financing Trust Fund) FOVISSSTE Fondopara la Vivienda de los Trabajadores del ISSSTE (Govemment Workers' Housing Fund) FSRL Financial Sector Restructuring Loan FSRP Financial Sector Restructuring Program FTAL Financial Sector Technical Assistance Loan IMSS Instituto Mexicano del Seguro Social (Mexican Social Security Institute) INFONAVIT Instituto del Fondo Nacional de la Vivienda de los Trabajadores (National Workers' Housing Fund Institute) ISSSTE Instituto de Seguridady Servicios Sociales de los Trabajadores del Estado (Institute of Security and Social Services for Govemment Workers) IV Seguro de Invalidezy Vida (Disability and Life Insurance) IVCM Invalidez, Vejez, Cesantia en Edad Avanzada, y Muerte (Disability, Old age, Severance, and Death Insurance Coverages) PROCE$AR Pension System Operator RCV Seguro de Retiro, Cesantia en EdadAva.nzaday Vejez (Old Age and Severance) MPG Minimum Pension Guarantee NAFTA North American Free Trade Agreement SAR'92 Sistema de Ahorro para el Retiro (Retirement Savings System of Individual Accounts, operating from May 1992 to January 1997) SHCP Secretaria de Hacienday Credito Pdblico (Ministry of Finance and Public Credit) SIEFORE Sociedaes de Inversi6n Especializadas de Fondos Para el Retiro (Specialized Pension Fund) Vice President: David de 'Ferranti Country Director: Olivier Lafourcade Sector Director: Danny M. Leipziger Task Manager: P. S. Srinivas  FOR OFFICIAL USE ONLY TABLE OF CONTENTS page number Preface .......................................................... i Evaluation Summary ........................................................... ii Part One Contractual Savings Implementation Assessment I. Background. 1 II. Program Objectives. 2 III. Bank Support: A Phased Reform Approach. 3 IV. Achievement of Program Objectives. 5 V. Major Factors Affecting the Program .23 VI. Program Sustainability .24 VII. Bank Performance .26 VIII. Borrower Performance .28 IX. Assessment of Outcome .29 X. Future Operation .29 XI. Key Lessons Leared .30 Part Two Statistical Annex .33 Appendixes A. Matrix of Compliance with Policy Actions B. Memorandum Recommending Loan Disbursement (without attachments) C. Borrower Contribution to the ICR (SHCP) D. Map This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   1. IMPLEMENTATION COMPLETION REPORT MEXICO SECOND CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM (Loan No. 4343-ME) Preface This is the Implementation Completion Report (ICR) for the Second Contractual Savings Development Program (CSDP II) Adjustment Loan in Mexico, for which Loan No. 4343- ME in the amount of US$400 million was approved on June 11, 1998 and made effective on December 14, 1998. This single tranche loan was fuilly disbursed upon effectiveness, December 14, 1998, which was within the time frame for effectiveness envisaged at the time of Board presentation of CSDP II. The ICR was authored by Mr. P. S. Srinivas, Financial Economist of the Latin America and Caribbean Region, and was reviewed by Mr. Fernando Montes-Negret, Sector Leader, FPSI for Mexico. The borrower provided comments that have been incorporated into the ICR and are reproduced (translated and unedited) in the annexes to the ICR. Preparation of this ICR was initiated during April 18-24, 1999 and continued in subsequent missions for other financial sector work in Mexico. The report is based on material in the project file, interviews with key participants, and findings from some of the Bank's other financial sector operations in Mexico.   ii. IMPLEMENTATION COMPLETION REPORT MEXICO SECOND CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM (Loan No. 4343-ME) Evaluation Summary Introduction 1. A key recognition by the Mexican Government in the aftermath of the 1994 peso crisis was the importance of raising its shallow pool of domestic savings to be able to better cope with future economic stress situations. Acting on this recognition, the Government introduced a package of social security reforms as an important element of mobilizing long term domestic savings. These reforms were also aimed at addressing the expected actuarial deficits that the public pension system would soon incur due to a combination of demographic trends and unsustainable benefits. The Government considered the time opportune to simultaneously create a basis for improved domestic savings and reform of the public pension system when it was still affordable. 2. The Government's Contractual Savings Development Program (CSDP) was the first nation-wide pension reform supported by the Bank. The Bank's support to this sector began with the preparation of an economic report in 1990, which provided a detailed analysis of contractual savings issues and set out some policy options for reform. The Bank's participation in this sector accelerated since late- 1994 with the provision of advice and technical support in the area of pension reform and capital market development. This work culminated in a decision to support the Government's reform efforts through a series of single-tranche adjustment operations. The first lending operation in support of the CSDP was approved by the Board on December 17, 1996 for US$ 400 million. The Inter- American Development Bank (IDB) co-financed this first phase with a two-tranche loan of $300 million. The ICR for this first project judged the outcome of CSDP's first phase to be highly satisfactory. CSDP II was the second single-tranche loan which supported the second phase of the reform of the contractual savings sector. A loan of $400 million was approved on June 11, 1998. Program Objectives 3. The Bank's support to the Government was based on an agreed medium-term strategy and CSDP II was the second in a planned series of operations to support the Mexican pension reform program and complementary financial sector reforms. The program has five long-term aims: (i) to increase the equity, efficiency, and sustainability  of the old age security system and to gradually expand effective coverage; (ii) to establish a financially viable pension system; (iii) to limit the fiscal impact of the current pension system and ensure transparency of the fiscal costs of transition; (iv) to enhance the development of capital markets by stimulating greater private financial intermediation, and to increase the array of financial instruments and contracts available; and (v) to raise the level of institutional savings and improve the allocative efficiency of domestic savings. 4. The first phase of the CSDP focused on the establishment of the legal, regulatory, and institutional framework for the reform of the country's old-age social security system. CSDP II concentrated on the actual implementation of the reformed pension system including: (a) implementing, consolidating, and fine-tuning the reformed system for private sector workers by: (i) ensuring a flexible and responsive regulatory framework; (ii) initiating operation of the reformed system and increasing its efficiency; (iii) transferring SAR92 balances from the Central Bank tc individual AFORE accounts; (iv) fine-tuning investment policies and improving risk management; (v) strengthening supervision and enforcement; and (vi) initiating paymenlt of disability and survivors benefits by private insurers; (b) updating estimates of the fiscal costs of transition; (c) deepening reforms to INFONAVIT to ensure adequate returns on the housing sub-account; (d) advancing in the technical preparatory work for the reform of the public pension systems; (e) sustaining public confidence through education and information; and (f) advancing in the implementation of complementary financial market initiatives. Implementation Experience 5. The first phase of the CSDP had a highly satisfactory implementation experience'. The Mexican Congress approved legislation establishing the new system in December 1995. A second legislation in May 1996 set out the structure and powers of CONSAR, the regulator of the new system and laid out the guiding principles for the establishment, operation, and supervision of the new private pension fund managers (AFOREs) and the pension funds (SIEFOREs). The new system came into effect on July 1, 1997. 6. The implementation experience of the second phase supported by CSDP II, while satisfactory, has been a more qualified success. CSD:P II had two major components of reform - one component dealing with implementation of the newly privatized pension system and the other dealing with reforms to INFONAVIT - the housing fund to which 5% of workers' wages are channeled. Together the reforms were aimed at placing the retirement income component of Mexico's social security system for private sector workers on a sustainable basis. The Implementation Completion Report for CSDP I (Report No. 17771, May 5, 1998) rated the project highly satisfactory.  iv. 7. The implementation of the first component can be judged to have been highly satisfactory. The private pension system has been placed on a sound footing through satisfactory implementation of the Retirement Savings System Law, although further work on several aspects of the system is needed. The second major component, dealing with reforms aimed at improving the administrative structure, operations, and credit policies of INFONAVIT met with mixed success. The reforms were executed to the letter of the Government's commitment and to the satisfaction of the Bank as required for the disbursement of the loan. Subsequent to loan disbursement however, INFONAVIT decided not to immediately implement the reforms approved by its Board. Even after a delay of almost a year, INFONAVIT has thus far only partially implemented the reforms originally approved in the resolutions of its Board. In the view of the Bank Team that prepared the loan, the delay in and partial nature of the implementation of the reforms by INFONAVIT has undermined the fundamental spirit of the agreements reached between the Bank and the Government. Expected improvements in INFONAVIT's financial performance were, therefore, also delayed. It is unclear at this stage that the reforms to INFONAVIT contemplated in the loan will either be implemented fully or if implemented with substantial modifications, will have significant impact on its operations. Given the expected expansion of INFONAVIT's lending program in 1999, delays in adopting the reforms are likely to further damage its already weak financial status. It is important to keep in mind that the implementation of the reforms lay beyond the ability of the Government alone, due to the degree of autonomy enjoyed by INFONAVIT on the basis of the law governing its operations2. Despite this, the very involvement of reforms to INFONAVIT in the pension reform agenda and the technical work done in the process of arriving at the agreements of specific reforms have succeeded in highlighting the problems with the institution and generating awareness of the importance of reforms to INFONAVIT to ensure the sustainability of the pension reform. The implementation of this second component of the loan can only be evaluated as partially successful. Given the importance of INFONAVIT to the overall social security reform program and the partial progress made on improving its financial performance, the implementation of the overall program is rated satisfactory. Performance 8. Borrower performance in the identification, preparation, and implementation of the project was highly satisfactory. With SHCP in the lead, an exceptionally qualified core team was created that maintained a coordinated inter-institutional reform program. The component of the program dealing with CONSAR and the private pension system was carried out with a minimum of delay on technical and legal aspects. The INFONAVIT component of the program, understandably involved significantly more difficult negotiations and technical work. The Bank Team had limited access to technical data and assistance from INFONAVIT, but the reform team in place provided all possible 2 INFONAVIT is governed by a tripartite Board of Directors with participation of the labor unions, representatives of the building industry (developers), and the Government.  V. support within the constraints. In this operation, the entire reform agenda regarding INFONAVIT was intermediated with the reform team from SHCP. The Bank did not have any official interaction with representatives of INFONAVIT through out the project preparation and implementation. The problems with implementation of reforms to INFONAVIT are attributable largely to the complex political dynamics of the reform. The Government did indeed meet all of its commitments under the loan to the satisfaction of the Bank, although later events detracted from the effective implementation of the INFONAVIT component of the reforms. Overall, the Mexican authorities should be commended on the degree of professional capacity that they brought to the achievement of the second phase of the program and their commitment to the reform of the social security system despite the difficulties faced, especially with regard to INFONAVIT. 9. Bank performance in the implementation of the second phase was also highly satisfactory. The Bank continued its close involvement with the process of pension reform in Mexico and responded in a timely fashion to the Government's request for financial and technical support. Bank staff also displayed significant awareness of the political realities of the situation in Mexico and tailored the operation to be effective within prevailing constraints. While the policy actions on the private pension system were relatively easier, those regarding INFONAVIT presented a significantly greater challenge. A number of policy choices to reform INFONAVIT were evaluated by the project team during project preparation. As mentionecl in the President's Report (Report No. P7239-ME), the reforms that would have been the first best from a technical perspective would have required important changes to INFONAVIT's law which, in SHCP's and Bank staff's judgement, were not feasible at the time. The policy approach adopted by the Government through the gradual implementation of an agreement between all parties in the management of INFONAVIT could have had a major impact on improving INFONAVIT's operations and finances and correspondingly on the sustainability of the pension reform. Hence, this more pragmatic and feasible approach was adopted by staff. Staff also identified the possible lack of progress with reforms in INFONAVIT as a risk facing the project in the President's Report. Program Sustainability and Assessment of Outcome 10. The sustainability of the second phase of the reforms supported by CSDP II is subject to several risks both as far as the AFORE system is concerned and as regards INFONAVIT and its impact on the pension system. The sustainability of the new pension system can only be judged over the long run - over twenty years - when the first workers in the transition generation opt for their accumulated retirement assets rather than the IMSS benefits under the government's minimum pension guarantee. However, it is fair to state that the new private pension system has gained a, substantial degree of strength and public support and hence seems to be on a sustainab[le footing. The high percentage of private sector workers opting for the new system, the substantial financial investments  vi. made by the AFOREs, and the effectiveness of a highly regarded regulator bode well for the sustainability of the private pension system. While there are important long-term issues such as SIEFORE investments in domestic and international equities (they are currently allowed to invest largely in government paper), choice to workers of multiple SIEFOREs, maintaining and further developing institutional strength of CONSAR, autonomy of CONSAR etc., risks to the overall system's sustainability are less likely to arise from this component of the pension system and more likely from INFONAVIT's financial performance. It seems that at least as of now, the program of measures to restructure INFONAVIT has not had the desired degree of support for implementation and, therefore, is likely to have only a limited impact at best on its financial performance. If no major reforms to INFONAVIT are undertaken to change the fundamental ways in which it does business, in the instruments it uses to do so, and in its structure of its governance, almost 40% of the workers' pension contribution could continue to earn rates of return that are poor in absolute terms and also in comparison with those earned on AFORE contributions. They could also continue to be substantially negative in real terms. This will have a significant negative impact on the welfare of the workers who are not entitled to switch back to the benefits of the old system' and those who do not benefit from INFONAVIT loans. The Government's future pension liability to the transition generation could be significantly higher than anticipated at the time of undertaking the pension reform if a majority of these workers opt for the old IMSS benefits due to poor INFONAVIT returns. 11. Overall, the outcome of the implementation of the program's second phase is considered satisfactory although the degree of its sustainability is unclear at this stage. While the Government's achievements in introducing a new private pension system are substantial and creditable, the limited progress on reforms to INFONAVIT could be an impediment to its sustainability as was contemplated during the preparation and supervision of the project. Lessons Learned 12. The principal lessons learned from the implementation experience of the second phase of the CSDP are: (i) Importance of Client Commitment to Reform. The implementation of the private pension fund system has been a major success and indicates the importance of client commitment to and ownership of the reform program. The Government's strong commitment to the reform of the private pension system ensured that the design, negotiation, and implementation of the reform was done in a collaborative environment with necessary technical and financial support of the Bank. The client played a leadership role in ensuring the credibility of the program and the Bank provided sound 3The transition generation of workers has this "lifetime switch" option.  vii. technical advice and disseminated best practice. The cooperative environment of work between the Bank and the Government ensured that this part of the reform program was a success. (ii) Difficulty of Dealing with Reform of A Highly Political Institution. The less successful experience with reform of INFONAVIT is an excellent example of the difficulties of reforming an institution that is highly political with entrenched vested interests and traditionally a strong source of patronage. It was clear throughout the process of project preparation and implementation that the Government itself was strongly committed to reform of the institution. However, the governance structure of the institution continues to give it an enormous amount of independence from the Government and the Government's commitment was simply not enough to implement the necessary reforms to the full extent. From the Bank's point of view, dealing with INFONAVIT was simultaneously critically important and difficult to implement. In the design of CSDP - the first pension reform loan - the Bank accepted the Government's decision to include INFONAVIT in the reform process. While this decision was sound, given the large fraction of pension contributions controlled by INFONAVIT, it also introduced a "problem" in project design that was almost certain to continue to be a thorny issue in future Bank operations in the sector. The Bank displayed keen sensitivity to the politically charged nature of the reforms and kept a low profile throughout the negotiations and implementation. This project must be one of the few instances of Bank operations where reforms to an institution were negotiated without any direct official contact with the institution involved. Based on the experience with INFONAVIT, the Bank needs to keep in mind that reform of political institutions is extremely difficult, even with a committed Government. Despite all the difficulties, however, it is critical to continue working on such reform issues in order to achieve the objective of improving the returns on pension contributions to workers and placing the overall social security system on a sustainable basis. (iii) Importance of Structuring Loan Conditionality. Bank operations dealing with reform of politically sensitive issues such as social security call for ensuring that the loan conditionality is adequate for program success while being practically achievable. This is often a difficult balancing act, given the limited amount of political capital available for the reform effort. In such situations, the Bank may sometimes need to structure its loan conditionality so that disbursement occurs after actual evidence of implementation, rather than after agreement to implement. An alternative would be to evaluate the conditions necessary for continued Bank support of the future reforn process incorporating the lessons learned from the support provided thus far. The limited success with INFONAVIT indicates that the Government- simply could not ensure full implementation of reforms that it managed to get approval of by INFONAVIT's Board.  viii. (iv) Selection of An Appropriate Instrument. The experience with both the first two CSDP loans indicates that the choice of a single-tranche adjustment operation (STO) as the lending instrument by the Bank was appropriate. The STO is a lending vehicle designed by the Bank specifically to protect the integrity of lengthy adjustment operations from significant political shifts in borrowing countries. Through the use of the STO, the Bank reduced the risk of delays and failure in the achievement of the program's long term aims by locking the client into an overly ambitious and politically sensitive policy agenda. Had the Bank chosen a traditional multiple tranche option, it is unclear whether even the limited reforms that have been achieved in fNFONAVIT would have been possible. This is borne out by the experience of the IDB, which chose a multiple tranche instrument with relatively more general conditionality. The disbursement of the IDB's second tranche occurred based largely on the more specific actions taken by the Government as part of CSDP II conditionality. The STO and its requirement that reform be implemented prior to disbursement provides the Bank with valuable leverage that can be used to make the institution a more effective partner in the development process. (v) Importance of Team Continuity. There was substantial continuity of teams - both on the Government's side and on the Bank's side - during the preparation and implementation of both the CSDP loans. The good working relationships and mutual trust and respect that was engendered due to this stability of teams considerably facilitated work on a complex reform.   Mexico: Second Contractual Savings Development Program (CSDP 11) Implementation Completion Report. Page I PART ONE: PROJECT IMPLEMENTATION ASSESSMENT I. BACKGROUND 1. In response to the financial crisis that erupted in December 1994, the Governiment of Mexico embarked on an ambitious program of fiscal and monetary reform. As a result of this effort, Mexico has achieved substantial progress in its adjustment objectives. The country has rebuilt its depleted reserves, improved its external debt profile, and regained access to international capital markets. Mexico has fared relatively well compared to the rest of Latin America in the more recent global economic turmoil and collapse of oil prices in 1997/1998. The strategy of a conservative fiscal policy, monetary tightening, and flexible exchange rate regime has been successful in short-term macroeconomic management. 2. One of the main points of financial vulnerability of the Mexican economy as it faced the 1994 peso crisis, was its shallow pool of domestic savings. The Zedillo administration considered social security reform as a key element of its long term strategy to increase the volume of domestic savings and provide the institutional basis through which domestic savings could be channeled to productive investment with greater efficiency. In addition to the expected actuarial and cash deficits that the existing public pension system would soon incur, the administration was aware of the important advantages of a confluence of economic and demographic trends that would make reform of the private-sector pension system both viable and affordable. 3. Mexico had conducted an earlier experiment with a multi-pillar pension system in May 1992, that included a second pillar of individual retirement accounts. Because of political compromises that had to be made in the system design in the process of introduction of the SAR system, this first attempt at a defined-contribution system was largely a failure. However, it provided a valuable introduction for Mexican authorities to the difficult task of pension reform and provided a platform of experience for future work in the reform of the social security system. 4. In December 1995 the Mexican Congress approved legislation (the new Social Security Law - Ley de Seguro Social) modifying the public pay-as-you-go, defined- benefits scheme to establish a privately managed, mandatory, defined-contribution scheme for private-sector workers affiliated to IMSS. A second legislative package on the implementation of the reform (the Retirement Savings Systems Law - Ley de los Sistemas de Ahorro para el Retiro), enacted in May 1996, set out the structure and powers of CONSAR, the market regulator, and provided guiding principles for the establishment, operation and supervision of pension fund administrators (AFOREs) and specialized mutual funds for pensions (SIEFOREs). Under the 1997 reform, the public IVCM system was separated into Old-Age and Severance insurance (RCV - Seguro de Retiro, Cesantia en Edad Avanzada, y Vejez), and Disability and Life Insurance (IV - Seguro de Invalidez y Vida). The reform became effective on July 1, 1997.  Page 2: Implementation Completion Report Mexico: Second Contractual Savings Development Program (CSDP 11) 5. The Mexican Government's Contractual Savings Development Program was the first nation-wide pension reform program supported by a loan from the Bank. The Bank used a new lending instrument in order to support the reform through a series of single- tranche adjustment operations (STOs) in order to protect the integrity of a lengthy adjustment process from significant political shifts. 4 The Bank's first loan in support of the first phase of the CSDP - focused on the establishment of the legal, regulatory, and institutional framework for the reform of the country's old-age social security system - for US$400 million was cofinanced with a two-tranche Sector Adjustment Loan of US$300 million, by the Inter-American Development EBank. 6. The Bank continued its support to the overall CSDP of the Government through technical assistance and a second loan of US$400 million that supported the second phase of the CSDP. This second phase concentrated on the actual implementation of the reformed pension system and reforms to INFONAVIT. II. PROGRAM OBJECTIVES 7. The medium term contractual savings development program: The reform of contractual savings is one of the key goals in the Government's National Development Plan (1995-2000). It is a medium-term program aimed at: * increasing the equity, efficiency, and sustainability of the old age security system gradually leading to greater effective coverage; * implementing a financially viable pension s:ystem; * limiting the fiscal impact of the current pension system and ensure transparency of the fiscal costs of transition: * enhancing financial market development and reducing volatility by stimulating greater private financial intermediation and increasing the array of financial instruments and contracts available; and > contributing to enhance the allocative efficiency of domestic and, in the longer-term, to raising aggregate savings. 8. Objectives of the first phase of the CSDP: The shift of a country's pension system to a more equitable and financially sustainable one and the implementation of complementary financial sector reforms, is a long-term process. The Mexican Government could not afford - financially and politically - to tackle all aspects of the reform in one fell swoop. Also, the fine-tuning of the reform depends on the outcome of the implementation of the initial phase. The Government decided to initially focus its efforts towards the reform of the old age insurance scheme for private sector workers. During 1995-96 the Government implemented a number of policy actions that resulted in shift from a public PAYG, defined-benefit system to a privately managed, defined-contribution system. Also, 4Operational rationale for the choice of single-tranche adjustment lending is given in the World Bank Memorandum, "Introducing Single Tranche Operations in LAC", by Aysegul Akin-Karaspan (LATSO), February 1996.  Mexico: Second Contractual Savings Development Program (CSDP II) Implementation Completion Report: Page 3 the Government set up the supervisory framework for the private pension fund administrators and issued the investment rules to be followed by the pension funds. The specific objectives of the first phase of the reform were the: (a) introduction of the legal and regulatory framework needed to establish the new pension system and to regulate and supervise private pension fund administrators; (b) design and issuance of an investment management regime; (c) assessment of the fiscal costs of the transition; (d) initiation of improvements in the performance of INFONAVIT; (e) individualization of accounts and strengthening the capacity of IMSS to manage the new pension system; and (f) encouragement of public confidence in the new system through education and promotion. 9. Objectives of the second phase of the CSDP: Full realization of the objectives of the reform depended on the consolidation and fine-tuning of the reforms initiated during 1995-96, on maintaining the necessary flexibility to cope with implementation challenges, as well as addressing a number of design limitations. In addition, it was considered essential to improve the financial performance of INFONAVIT in order to provide better returns to workers on their overall pension contributions. The second phase of the reform concentrated on the actual implementation of the reformed pension system including: (a) implementing, consolidating, and fine-tuning the reformed system for private sector workers by: (i) ensuring a flexible and responsive regulatory framework; (ii) initiating operation of the reformed system and increasing its efficiency; (iii) transferring SAR92 balances from the Central Bank to individual AFORE accounts; (iv) fine-tuning investment policies and improving risk management; (v) strengthening supervision and enforcement; and (vi) initiating payment of disability and survivors benefits by private insurers; (b) updating estimates of the fiscal costs of transition; (c) deepening reforms to INFONAVIT to ensure adequate returns on the housing sub-account; (d) advancing in the technical preparatory work for the reform of the public pension systems; (e) sustaining public confidence through education and information; and (f) advancing in the implementation of complementary financial market initiatives. 10. The CSDP II loan's objectives were clear and appropriately designed for a single tranche operation. They were consistent with the Government's policy agenda, as articulated in the National Development Plan for 1995-2000, and the National Plan to Finance Development 1997-2000. They were also in line with the Bank's Country Assistance Strategy (CAS) for Mexico discussed by the Bank Executive Directors on October 17, 1996 that set the establishment of a financial environment to encourage greater domestic savings as a priority in the Bank's lending program. III. BANK SUPPORT: A PHASED REFORM APPROACH 11. The Bank's support in the area of contractual savings in Mexico began in 1990 with the preparation of an economic report, which provided a detailed analysis of contractual savings issues. The two CSDP loans were the outcome of a close dialogue between the Bank and the Government on the development of Mexico's financial sector, the need to improve the allocation of financial resources, and set the basis for the effective channeling of domestic savings. The Bank's participation accelerated in late-  Page 4: Implementation Completion Report Mexico: Second Contractual Savings Development Program (CSDP II) 1994 with the provision of advice and technical support in the area of pension reform and capital market development. This culminated with the decision to support the Mexican Government's reform objectives through a series of one-tranche adjustment operations. 12. In order to appreciate the strategic framework for the Bank's support, it is useful to see the evolution of policy actions supported by the Elank. * 1995-96 policy reforms supported by CSDP I established the legal and regulatory framework to shift the pension system for private sector workers to a defined contribution, privately-managed scheme; v issued the investment management rules for the pension funds; strengthened the supervisory agency (CONSAR); estimated fiscal transition costs, including sensitivity analysis; took first steps to improve the financial performance of INFONAVIT; initiated public awareness campaign to educate the public and bolster support for the reform; and initiated the implementation of complementary financial market initiatives. i January 1997-April 1998 policy reforms supported by CSDP II / implemented, consolidated, and fine-tuned the reforn to the pension system for private sector workers; / successfully initiated operation of centralized collection and record-keeping system; / advanced in the design of reforms of INFONAVIT to ensure adequate returns on the housing sub-account; V updated estimates and sensitivity analysis of the fiscal costs of the reform; v advanced in the technical preparatory work for reform of the public sector and state level pension systems; sustained public confidence through education and information; and / continued implementation of complementary financial market reforms. * FutureAgendaforBanksupport- benchmarksfor afuture thirdphase: implement further and substantive reforms to INFONAVIT in order to improve its financial performance; strengthen CONSAR's regulatory independence; / introduce greater portfolio diversification including investment in equities for SIEFOREs; / design and implement measures to contain/reduce the administrative costs of the system; take measures aimed at sound development of annuities markets; / implement measures to reduce the cost of the disability and life insurance scheme; / ensure the financial viability of the pension schemes for public sector workers; and identify specific actions to increase coverage if reformed system has no significant impact.  Mexico: Second Contractual Savings Development Program (CSDP 11) Implementation Completion Report: Page 5 IV. ACHIEVEMENT OF PROGRAM OBJECTIVES 13. Given the structure of a single-tranche adjustment lending operation, most of the objectives of the second phase of the program were met prior to the loan's presentation to the Board. Details on the implementation, consolidation, and fine tuning of the new system, the strengthening of the regulatory framework, establishment and fine tuning of investment policies and risk management, and the measures agreed upon to deepen the reforms to improve the financial performance of INFONAVIT can be found in the President's Report, Report No. P7239-ME. An in-depth analysis of the implementation of the new AFORE system, the importance of INFONAVIT in the overall reform process as well as the challenges to the sustainability of the new system are also contained in the same report. As a condition of effectiveness, the Borrower was required to take certain key actions towards improving the financial performance of INFONAVIT. Evidence of the Borrower's compliance with all of the loan conditions is provided in Annex A: Matrix of Compliance with Policy Actions of this report. 14. Since CSDP II is part of an incremental process of reform, it is too early to assess fully the success of the reform in meeting its long-term aims, or to judge their sustainability. Nevertheless, an analysis of current indicators as to whether these long- term goals are likely to be achieved is vital to the continuing dialogue with the Borrower, and as a guide to future Bank operations for further reform of social security in Mexico. The key results of the second phase of the reform process and the operation of the new system in its first one and a half years are presented below. 15. The first phase of the CSDP had a highly satisfactory implementation experience'. The implementation experience of the second phase supported by CSDP II has been a more qualified success. CSDP II had two major components of reform - one dealing with implementation of the new privatized pension system and the other dealing with reforms to INFONAVIT. Together the reforms were aimed at placing the retirement income component of Mexico's social security system for private sector workers on a sustainable basis. The implementation of the first component can be judged to have been highly satisfactory. The implementation and consolidation of the private pension system and its regulatory structure has been successful and the system can be judged to have been placed on a sound footing. While further reform and fine tuning of the system is necessary, it is reasonable to state that the essential foundations of a sound privately managed pension system have been laid. The reforms aimed at improving the administrative structure, operations, and credit policies of INFONAVIT were executed to the letter of the Government's commitment to the Bank. The Board of INFONAVIT approved the necessary measures required for satisfaction of the conditions precedent to disbursement of the loan. Subsequent to loan disbursement, however, INFONAVIT has 5The Implementation Completion Report for CSDP I (Report No. 17771, May 5, 1998) rated the project highly satisfactory.  Page 6: Implementation Completion Report Mexico: Second Contractual Savings Development Program (CSDP 11) thus far taken only tentative steps towards partial implementation of the reforms agreed to in the resolutions of its Board. In the view of the Bank. Team that prepared the loan, the delay in implementation of some of the reforms and the partial nature of the reforms implemented have eroded the spirit of the reforms agreed to prior to disbursement. It is unclear at this stage that the reforms to INFONAVIT contemplated in the loan will either be implemented fully or if implemented with substantial modifications will have any significant impact on its operations. It is important to keep in mind that the implementation of the reforms lay beyond the ability of the Government alone due to the degree of autonomy enjoyed by INFONAVIT on the basis of the law governing its operations. The main success of the project has been in raising the necessity of reforms to INFONAVIT to the top of the agenda and in sensitizing the Government to the difficult work that lies ahead. A. Implementation and Consolidation of the 1997 Pension Reform Al. Regulatory Framework 16. Timely and flexible regulation of pension funds by CONSAR should play a major role in ensuring the success of the reform. Though justifiable as initial conditions or explained by the fragility of the financial sector and political constraints, some features of the initial regulatory framework may have limited the most productive long term investments and/or require more flexibility as the system evolves. To ensure the flexibility of the regulatory framework and to respond to additional regulatory needs after the initial implementation of the reforn, CONSAR has issued a number of key regulations (Circulares) since January 1997. These include guidelines for (i) general information disclosure from entities involved in the operation of the system to CONSAR; (ii) accounting and balance sheet information to be sent by AFOREs and SIEFOREs to CONSAR; (iii) the monthly report to be sent by each AFORE to CONSAR; (iv) general information disclosure by AFOREs to affiliates and the public; (v) prospectus for each SIEFORE; (vi) individual statement to be sent to workers' with the financial performance and balances of the AFORE and INFONAVIT accounts; and (vii) confidentiality of individual account information by entities involved in the operation of the system.  Mexico: Second Contractual Savings Development Program (CSDP II) Implementation Completion Report: Page 7 A2. Operation and Efficiency of the New Pension System (a) AFORE industry authorization, affiliation, market share limits, and switching rules 17. Authorization process. CONSAR has authorized 17 AFOREs in a timely fashion, ensuring that foreign-owned AFOREs receive equal treatment with Mexican-owned AFOREs. Since then four AFOREs have either merged with or have sold to others, reducing the number of industry participants to 14. CONSAR has handled this process of industry consolidation extremely well with little disruption to the smooth functioning of the overall system. 18. Affiliation Process. CONSAR issued the general rules governing the affiliation contract between the worker and his/her chosen AFORE on February 18, 1997. Since then, there has been an extremely positive initial response to the new system - as demonstrated by the affiliation of over 73% of potential workers by July 1, 1999. As of July 1, 1999 assets under management by the AFOREs totaled P$ 85.7 billion - equivalent to approximately US$ 8.5 billion (Figures la and lb). Figure la. Worker Affiliation by Month (February 1997-July 1999) 16,000,000 80% 14,000,000 70% 12,000,000 60% 0 10,000,000 60% 0)~8,000,000 400/ 0 5_ 4-j'/ 6,000,000 30% 6 Z 4,000.000 20% 2,000,000 10% 0% 4' _4 .61N 4 CP 4' 4 4' ' J ' 4' 4 4' 4 Month F No. of IMSS Workers k... of tMSS Workers  Page 8: Implementation Completion Report Mexico: Second Contractual Savings Development Program (CSDP 11) Figure lb. Assets under Management, by AFORE (July 31, 1999) 20,000.00 18,000.00 _ 16,000.00 14,000.00 - ____ _ ._- 0 ow 12,000.00 ---- - ~ - --- O 10,000.00 _.- _ _._ _.______-- 0 8,000.00 . . _-----_____. -_ _ _-.___ 6,000.00 4,000.00 2,000.00 AFOR~E 19. Market share limits and concentration of the industry. The law stated that for four years - beginning in 1997 - there would be a 17% maximum market share limit for each AFORE. This limit would then be increased to 20% after 4 years. CONSAR issued regulations which set the limit in terms of number of workers registered in each AFORE. To assure that no AFORE receives an unfair competitive advantage, CONSAR refrained from authorizing the first AFORES until it was able to grant simultaneous authorizations to a significant number of competitors (Figures 2a and 2b).  Mexico: Second Contractual Savings Development Program (CSDP I) Implementation Completion Report: Page 9 Figure 2a. Market Share of Affiliated IMSS Workers, by AFORE (July 31, 1999) 18% 16% --_ _ _ _ _ _ _ _ _ _ _ _ _ 14% __. _ -_ s210%---1I 6% - ___ ---- ----- l 4% 0% E ~ ~ ~ ~ ~ ~ ~~FR 27% - _. -l 1-l- -_| _ _- 2% /