Document of The World Bank FOR OFFICIAL USE ONLY REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S. A. WTTH THE GUARANTEE OF UNITED MEXICAN STATES FOR A FOURTH INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT May 15, 1979 FILE COPY Report No P E 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.

2 Currency Unit - Peso (Mex$) Since September 1, 1976 the Mexican peso has been floating and has fluctuated around Mex$ to the US Dollar since mid On May 4, 1979, the peso traded at per US dollar. Fiscal Year January 1 to December 31 Abbreviations ACF = Average yearly cost of borrowed funds to financieras (investment banks and investment banking departments of commercial banks) BANXICO = FOGAIN = Banco de Mexico Fondo de Garantia y Fomento a la Industria Mediana y Pequena (Trust Fund for Guarantees and Development of Medium and Small Scale Industry) FOMEX = Fondo de Fomento a las Exportaciones de Productos Manufacturados (Trust Fund for Promotion of Exports of Manufactured Products) FONEI = Fondo de Equipamiento Industrial (Trust Fund for Industrial Equipment) IDB = Inter-American Development Bank IFAD = International Fund for Agricultural Development NAFINSA = Nacional Financiera, S.A. PEMEX = Petroleos Mexicanos S.A. (Mexican Petroleum Company) PIDER = Investment Program for Rural Development

3 FOR OFFICIAL USE ONLY MEXICO FOURTH INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT LOAN AND PROJECT SUMMARY Borrower: Guarantor: Project Executing Agency: Amount: Terms: Relending Terms: Project Description: Nacional Financiera, S.A. (NAFINSA) United Mexican States Fondo de Equipamiento Industrial (FONEI), a Federal Government trust fund managed by Banco de Mexico, would carry out the industrial credit project. Studies on human resources would be coordinated by the Guarantor's Ministry of Education. US$175 million equivalent Seventeen years, including four of grace, at an interest of 7.9 percent per annum. For FONEI's ordinary credit operations (about US$163 million of the proposed loan would be applied to such operations) industrialists would receive loans in pesos and pay interest at two points above the average cost of funds to financieras (ACF); for technology subprojects interest would be three points below the ACF and pollution control subprojects would be financed at between two points above and three points below the ACF. Interest rates would be adjusted every six months to reflect changes in the ACF. (ACF stood at percent in January 1979.) FONEI would provide medium and long term financing to industrial enterprises through the commercial banking system to help finance machinery, equipment and services for high priority industrial projects, including projects to help develop technology and control pollution. The Bank loan would finance the foreign exchange component of FONEI financing over a period of about two years. The project would also help finance a training program on industrial project evaluation and supervision for financial intermediaries and FONEI's staff. A national study of human resources and technical and vocational training needs for further industrial development would be included in the project. The project presents a low level of risk with respect to the soundness of subprojects it would finance since FONEI is a mature financial institution; its institutional objectives may take longer to achieve. On the whole, the project presents a moderate level of risk. 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.

4 Estimated Cost and Sources of Financing: US$ million % Projected Loan Disbursements: A. Total cost of industrial subprojects 733 Financing: Project Sponsors Participating intermediaries Other local and foreign banks FONEI, of which: Internally generated funds and local borrowing (138) (18.8) Bank loan for subprojects (173) (23.6) B. The cost of training programs for financial intermediaries and FONEI staff is estimated at up to US$500,000 equivalent; half of the cost would be financed by FONEI from internal resources and half from the loan; C. The cost of studies of human resources and technical and vocational training needs is estimated at up to US$4.0 million equivalent; the loan would finance 47 percent of such costs and the Government would finance the balance. in US$ million Fiscal Years Annual Cumulative Staff Appraisal Report: No. 2473b-ME of May 10, 1979

5 INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A FOURTH INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT 1. I submit the following report and recommendation on a proposed loan to Nacional Financiera, S.A. (NAFINSA) with the guarantee of United Mexican States for the equivalent of US$175 million to help finance: (i) the foreign exchange component of the Industrial Equipment Fund's (FONEI's) financing over a period of about two years and (ii) the cost of a national study on human resources and training needs for further industrial development. The loan would bear interest at 7.9 percent per annum and would have a repayment period of 17 years, including 4 years of grace. For FONEI's ordinary credit operations (about US$163 million) resources would be onlent in pesos with final borrowers paying a fully adjustable interest rate two points above the average borrowing rate of financieras (ACF); for technology subprojects, interest would be at three points below the ACF and for pollution control subprojects interest would be at between two points above and three points below the ACF. The Government would carry the foreign exchange risk on the loan amount; FONEI would take the risk on interest and other changes. PART I: THE ECONOMY 1/ 2. Some of the major features of the Mexican economy were analyzed in "An Updating Report on the Economy of Mexico" (1110-ME), distributed to the Executive Directors on March 23, A special economic mission visited Mexico in April-May Its report has been discussed with the Mexican authorities and is about to be circulated to the Executive Directors. The discussion which follows reflects the principal and updated findings of the mission. Past Performance 3. For most of the three decades preceding the mid-seventies, Mexico was outstandingly successful in achieving rapid economic growth while maintaining stability in prices and the balance of payments. From 1940 to 1970, average GDP growth exceeded 6 percent per year in real terms, inflation averaged less than 5 percent per year from the mid-1960s to 1972, and the dollar value of the peso, fixed in 1954, was maintained until the September 1976 devaluation. The Government's role in this achievement was to carry out direct investments in infrastructure and in key industries such as power, steel and petroleum, while creating a stable regulatory and institutional framework, as well as good profit prospects, to induce private sector growth. 1/ Part I is substantially unchanged from the President's Report for a Second Fertilizer Project (R79-68) of March 30, 1979.

6 This strategy produced rapid growth, but did little to reduce contrasts within the Mexican economy. While land redistribution under the reform of 1915 was continued, most of the peasants who received land could not improve their economic status as they could not benefit from basic infrastructure, credit and technical assistance. Rapid population growth made social equity even more difficult to achieve. Population growth in Mexico accelerated steadily, primarily as a result of reduced death rates, and reached 3.4 percent per year by Despite economic growth, the high demographic growth rate made adequate absorption of the labor force in productive employment difficult. Some 40 percent of the labor force is either relatively unproductive and poorly paid, or openly unemployed. 5. During the 1970s, Mexico experienced increasing public sector deficits, inflation, large balance of payments deficits, capital flight and a marked slowdown in the real rate of growth of GDP, which dropped to less than 2 percent in the lowest annual growth rate experienced by Mexico since the mid-thirties. On September 1, 1976 the authorities abandoned the fixed exchange rate of pesos per dollar that had remained unchanged since 1954 and let the peso float; in recent months it has remained rather stable at rates fluctuating around pesos per dollar. Following the devaluation, Mexico obtained major support from the IMF. In the last quarter of 1976, Mexico was able to draw on the Fund for US$480 million. For , an Extended Fund Facility accompanied by a comprehensive three-year stabilization program was negotiated. The new Government ratified the agreement with the IMF shortly after taking office on December 1, 1976, and to date has complied with the program agreed upon with the IMF. Current Economic Policy 6. The present Government inherited a difficult situation. High inflation, large public sector deficits, increasing foreign indebtedness and lack of confidence in economic management indicated a need for economic stabilization. However, the situation also called for more expansionary policies; economic activity had slowed down, net private investment was virtually nil, and the gap between new job creation and growth of the labor force was increasing. High world prices for petroleum offered profitable investment opportunities in the petroleum sector; indeed, increased production for export of these products seemed by far the best way to meet a large part of Mexico's high debt service requirements in the coming years. 7. Faced with these conflicting needs and opportunities, the Mexican authorities have adopted a mixed strategy aimed at reducing lower-priority public expenditures and increasing public revenues, while proceeding with petroleum and other high-priority investments. The objectives of the Government's program include control of inflation together with a return to high rates of economic growth. Better management of public sector expenditures, more rational pricing and cost control in public sector enterprises, promotion of private savings, limiting wage increases to justifiable levels, and more effective cooperation with the private sector are important parts of the Government's economic strategy.

7 8. The measures instituted by the current Administration have produced good results. Inflation was brought back to 18 percent in 1978, down from an annual rate of more than 60 percent in the last quarter of 1976, immediately after the devaluation. The deficit in the current account of the balance of payments peaked at $4.2 billion in 1975 and declined to $2.0 billion in The favorable oil prospects and increasing capital inflows allowed it to increase again and it is estimated to have been $3.1 billion in Public sector net deficit also peaked at 8.6 percent of GDY in 1975 and declined to 5.4 percent of GDY in Mobilization of savings by the banking system has also been recovering at a strong pace. The GDP rate of growth is estimated at 6.5 percent in 1978 as compared to less than 1 percent in The outlook for 1979 is favorable; the rate of growth of the economy should increase while efforts to control the rate of inflation will have to be continued; the deficit in the current account of the balance of payments and the public sector's financial requirements are likely to remain at the 1978 levels in real terms. Economic Issues and Prospects 9. A comprehensive social program is gradually emerging. It is aimed at strengthening the political system, improving income distribution and the living conditions of the poor, increasing public sector efficiency and accelerating growth. The program takes into account two overriding economic priorities--energy development and adequate supplies of foodstuffs--and takes the form of a three stage economic strategy. The first stage--the stabilization period--was devoted to overcome the serious economic problems the present Government inherited. The second stage will be devoted to establishing the basis for attaining a high, equitable and stable rate of growth. During this stage efforts will be made to overcome supply bottlenecks, increase agricultural production, improve the marketing system, increase the efficiency and competitiveness of the country's industrial sector and create the conditions necessary for a more just distribution of the benefits of growth. Accelerated and equitable growth would be the characteristics of the third stage. 10. Mexico has the human, institutional and natural resources necessary to attain these ambitious goals. The short-run disequilibria that have affected the country during the mid-70s have been brought under control; the new petroleum riches and the country's ability to exploit them have greatly relaxed the financial constraints on growth. In his last State of the Union speech President Lopez Portillo announced that Mexico's present oil and gas reserves amounted to 20 billion barrels on July 31, 1978 and that probable and potential reserves amounted to 37 billion and 120 billion barrels, respectively. These figures were revised upward in January 1979 and proven oil and gas reserves put at about 40 billion barrels. Exploitation of these reserves should allow Mexico to increase production of crude oil, natural gas and petrochemicals from the equivalent of about 1.2 million bbl/day in 1976 to about 3.3 million bbl/day in 1982 and export earnings are projected to rise from about US$600 million in 1976 to approximately US$11 billion in 1982 (on the basis of very conservative price assumptions), not counting potential gas exports.

8 The challenge ahead is how to use these vast riches to help resolve Mexico's long-term development problems which include the following: (i) Population and Poverty. Many Mexican families have not participated in the sustained economic growth of the last several decades. As of 1975, about 3.6 million Mexican families--35 percent of the total--receive incomes less than one-half the national average. The members of most of these families work--more than half of them in agriculture--but they produce little and receive little. Mexico's labor force is now growing at about 3.1 percent per year; during the 1960s this growth rate was 2.0 percent per year. The challenge of providing productive jobs for both new entrants and existing underproductive workers is awesome; (ii) Stagnation in Agriculture. Crop and livestock production in Mexico, which had grown by 6 percent per year during and 4.2 percent per year during , grew at only 2.1 percent per year during , resulting in increased imports of corn and wheat; (iii) Regional Imbalances. The heavy concentration of people, production, and public services in the Mexico City area-- which has currently a population of about 12 million and is growing at over 5 percent each year--and the scarcity of productive employment and services for rural Mexicans are challenges to urban management, economic development, and social justice. They imply diversion of some of Mexico City's future growth to other regions, as well as the gradual concentration of scattered rural populations into small towns so that basic public services could be provided more economically and productive activities would have a better chance of developing. 12. In the medium term the prospects for resumption of economic growth with relative price stability are good. Poverty will remain a problem but the Government is taking steps to address it. The alleviation of the external constraint on growth brought about by the expected petroleum earnings (para. 15), together with the Government's efforts to increase public sector savings and to stimulate private investment, could produce economic growth of 7 to 8 percent per year in the remaining four years of the present administration. Resumption of economic growth combined with the intensification of the Government's family planning program, 1/ the new emphasis on rainfed agriculture, and the implementation of specific programs aimed at increasing productive employment, should help to address the structural problems mentioned above. 1/ On October 28, 1977, President Lopez Portillo announced the ambitious goal of reducing the population growth to 2.5 percent per year by 1982, then progressively to 1.8 percent by 1988, 1.3 percent by 1994, and 1 percent by the year About two-thirds of Mexico's population live in urban areas, well served by hospitals and health centers, with good family planning education and services. The program is now being extended to rural areas.

9 13. In agriculture, the current administration has undertaken a farreaching administrative reform that will allow broader and more effective Government action in the sector. Emphasis is laid on productivity gains and yield increases in both irrigated and rainfed areas. The previous goal of self-sufficiency in agricultural goods is being rephrased in terms of the sector's overall capacity to pay for its own imports. Irrigation is fostered through programs for construction of irrigation and drainage works and for rehabilitation of existing irrigation districts to increase efficiency of water use. The new emphasis on rainfed agriculture, relatively neglected in the past, should lead to an increase in the productive potential of vast areas currently under-exploited and to a reversal of past trends towards larger income disparities between the modern and traditional agricultural subsectors. These initiatives, together with the realistic exchange rate, promise a resumption of production growth for both domestic and export markets and an improvement in the living conditions of the rural poor. 14. Industry has potential for considerable growth in many sectors, including import substitution in chemicals, petrochemicals and capital goods as well as exports of many different manufactured products. The Mexican Petroleum Company (PEMEX) has already started an ambitious investment program to produce a variety of primary petrochemicals on a large scale for both domestic consumption and export, and it is expected that the private sector will complement this by investing in the production of secondary petrochemicals. Tourism export earnings are also expected to increase. 15. Paramount among the benefits of recent public sector investments are the new possibilities opened to the Mexican economy through the discoveries of rich petroleum fields. The Government has decided to use these large hydrocarbon resources to help manage Mexico's heavy debt service burden and to enhance the country's development prospects. The additional domestic demand likely to occur, due to increased public investment and programs aimed at increasing employment and the productivity of the poor, will have to be satisfied partially through increased imports. The import capacity will be increased considerably, however. Rapidly increasing petroleum exports and favorable tourism earnings prospects, the recovery of agricultural exports and resumption of growth of manufactured exports have strengthened the balance of payments outlook and will keep the current account deficit at reasonable levels despite higher imports. 16. Mexico's public debt service ratio has been increasing over the recent past and reached 48 percent in This comparatively high ratio is more a reflection of the low level of exports relative to GNP and the high proportion of Mexican borrowing from commercial banks than it is an indication of a high level of external debt relative to the size of the economy. When middle income developing countries are ranked by the ratio of external public debt to GNP, Mexico ranks as average. The public debt service ratio is estimated to have peaked above 50 percent in 1978 and, mainly as a result of the rapid expansion of petroleum exports, is expected to decline to levels of around 40 percent in the early 1980's. Debt service on Bank loans amounts to about 4.3 percent of public debt service; this ratio is projected to decrease over the next years to some 3.6 percent in The Bank currently holds

10 - 6 - about 7 percent of Mexico's total medium- and long-term public debt, and this ratio is not likely to change in any significant way over the next few years. Mexico remains creditworthy for borrowing on conventional terms considering economic strategy which the Government has adopted to realize it. PART II - BANK GROUP OPERATIONS IN MEXICO 1/ Bank Operations 17. As of March 31, 1979, Mexico had received 57 loans from the Bank amounting to US$3,128.9 million net of cancellations and terminations; of these, 33 loans totalling US$1,486.4 million were fully disbursed. The Bank held US$2,595.3 million of which US$1,086.2 million had not yet been disbursed. Some 40 percent of Bank lending has been for agriculture and rural development (19 loans for US$1,264.4 million), 23 percent for power (12 loans for US$704.8 million) and 17 percent for transportation projects (12 loans for US$546.7 million); the remaining 20 percent has been for industry (US$352.5 million), water supply (US$130 million), tourism (US$114 million), and urban development (US$16.5 million) projects. Mexico was carrying out a stabilization program (para. 9), and because of scarcity of counterpart funds some projects fell behind schedule in 1976 and Adequate budget support for Bank projects has now been secured. Annex II contains a summary statement of Bank loans as of March 31, 1979 and notes on the execution of ongoing projects. IFC Operations 18. As of March 31, 1979, IFC has made investment commitments in 17 companies in Mexico, for a total of US$202.4 million, of which US$130.5 million had been sold, repaid or cancelled. The balance held by the Corporation, US$71.9 million, consists of US$62.1 million in loans and US$9.8 million in equity. A summary statement of IFC investments as of March 31, 1979, is presented in Annex II. Bank Strategy 19. The main objectives of Bank lending in Mexico have been to: (i) support policies and programs leading to a wider distribution of the benefits of economic growth; (ii) help finance projects that make directly or indirectly, significant contributions to output, exports, and employment; and (iii) help resolve critical adjustment problems that Mexico is currently facing. Therefore, the Bank is preferentially supporting projects of high social priority that help the rural or urban poor, projects that promote higher levels of employment and production and those that help to decentralize economic activity. 1/ Part II is substantially unchanged from the President's Report for a Second Fertilizer Project (R79-68) of March 30, 1979.

11 Because of the difficult structural problems of Mexico's agriculture and the sector's crucial importance to the country's further development, the Bank has made agriculture the leading sector for its lending. The Bank agricultural lending program for Mexico has four goals: first, to increase productivity of presently cultivated lands through selected programs of irrigation rehabilitation and on-farm improvements; second, to improve the productivity of small farmers who receive the benefit of most Bank lending through programs for (a) rural development, (b) rainfed agricultural development, (c) bringing new areas under cultivation, and (d) establishing irrigation and drainage units; third, to complement infrastructure investments with general support services including agricultural extension and marketing programs and provision of medium-term credit; and fourth, to promote off-farm employment opportunities in rural areas through programs of agro- and rural-industries. The Bank has made nine loans in FY 72 through 78, totalling US$835 million, for irrigation, rural development and agriculture and livestock credit programs. A US$25 million supplemental loan for the Rio Panuco Irrigation Project and US$60 million loan for a small-scale agricultural infrastructure project were approved by the Executive Directors in FY79. A US$92 million loan for the Rio Sinaloa/Rio Fuerte Irrigation Project has been submitted to the Executive Directors for their consideration. Projects for rehabilitation of irrigation districts, water control, rural development and support services are in preparation for possible future support from the Bank. 21. Past Bank lending for industry has been aimed at (a) assisting the Government's efforts to reduce the balance of payments deficit, (b) decentralizing industrial activities away from the major and increasingly congested urban areas and (c) promoting greater employment in the sector by supporting medium and small scale industry. A large steel project is now operating in a previously underdeveloped area on the west coast of Mexico. A fertilizer project strengthens development of the resource-rich southeast region and the central area and a $80 million loan for a fertilizer project approved by the Executive Directors in FY79 gives further support to the development of an industrial center on the west coast of Mexico. A project to promote the development of small- and medium-scale enterprises and a third industrial equipment fund project were approved by the Executive Directors in FY78; both offer support to the private sector at a time of rapid expansion. The proposed project aims at strengthening financial intermediation and would support industrial subprojects with a significant production and employment impact. A capital goods industry project is under study for possible Bank support. 22. As regards infrastructure, the Bank's operations have been focused on investments in key areas of the country as well as on institutional reforms and sector policies aiming, inter alia, at suitable pricing mechanisms to help generate additional resources for investment financing. The airports development project (FY74) was designed to support the Government's policy of regional integration; the third railway project (FY76) supported improvements of institutional aspects and financial management of the sector. The Mexico City (FY73) and medium cities (FY76) water supply projects have been instrumental in the establishment of specialized institutions for efficient provision of drinking water and in the pricing of water at levels more closely related to costs. A highway sector project loan was approved by the Executive Directors in FY79. A second airports project is being processed.

12 The Government and the Bank have long recognized the regional economic disparities prevailing in Mexico (para. 11). In June 1976 the Government adopted the Law of Human Settlements to provide a new institutional framework to deal with the pressing problems of over-concentration of economic activities in the larger metropolitan areas. The Government has recently adopted a National Urban Development Plan that spells out its regional development priorities in operational terms, and several projects are now being prepared to meet the needs for basic urban services for poor families and to provide key regional infrastructure in selected priority cities. One such project, to assist in the development of the Lazaro Cardenas conurbation area on the West Coast, was approved by the Executive Directors in FY78, and another project for the southeast part of the country will be appraised in the coming months. 24. The Inter-American Development Bank (IDB) is the second largest source of multilateral aid to Mexico. The IDB has made loans totaling US$1,830 million. Over sixty percent of this lending has gone for agricultural and rural development projects, and the balance for transportation, industry, and tourism infrastructure. In 1978, the IDB approved three loans totaling US$236 million for coal mining, irrigation, and tourism projects. The IDB and the Bank have worked in parallel on several projects; most recently the IDB and the Bank have each made loans for the National Program for Small-Scale Agricultural Infrastructure, the Investment Program for Rural Development (PIDER), agricultural and livestock credit, small- and mediumscale industries, and hotel development. The International Fund for Agricultural Development (IFAD) is also considering a rural development project in the state of Oaxaca; Bank staff is assisting in project preparation and appraisal. PART III - THE INDUSTRIAL AND FINANCIAL SECTORS 25. From 1960 to 1973, manufacturing output increased at an annual rate of over 8 percent and the share of manufacturing in CDP increased from 19.2 to 22.8 percent in the same period. Growth rates began to slacken in 1974, mainly as a result of uncertainty in the private sector due to inflation, unclear policies towards the private sector, public sector preemption of credit and imports becoming unreasonably cheaper than domestically produced goods. The stabilization program started in 1977 following the massive devaluation of the previous year, did much to restore confidence, and by 1978 investment by the private sector was taking place at a rapid pace in most industrial subsectors, in many cases to make up for investments which had been postponed during the earlier period of uncertainty. Preliminary estimates indicate that industrial output increased by 10 to 11 percent in 1978 and that many industries are approaching the limits of their installed capacity. 26. Structural changes associated with a growing population and increasing incomes have emerged within the sector since The share of traditional consumer goods in manufacturing value added has fallen, while that of intermediate goods and engineering industries has risen. The production of durable consumer goods rose quite substantially over the past

13 - 9 - decade, but production of capital goods did not grow much, and this subsector is less developed in Mexico than in other countries of comparable size and stage of development. Mexico has relied heavily on imports for its capital goods needs and these accounted for one third of its total imports in Protection 27. The import substitution approach to industrialization used in the past depended heavily on import controls with generally moderate tariff levels. Nevertheless, internal competition made possible by the relatively large internal market and open border areas, contributed to the growth of a reasonably efficient industrial sector in most branches. The Mexican authorities have sought since 1976 to improve the efficiency of the industrial sector, to adapt it to international conditions and make it more export oriented. Imports began to be liberalized at the end of 1977 by reducing the number of products subject to import licenses. By the beginning of 1979, slightly more than two-thirds of the items in the customs nomenclature were no longer subject to prior licenses; however, items still subject to controls accounted for two thirds of the value of total imports in An inter-ministerial committee is currently studying effective protection to develop a program for further liberalization. Exports 28. Measures initiated in 1970 to develop manufactured exports were quite successful. These included reimbursement of indirect taxes, credit on concessionary terms and institutional support for export promotion. Between 1970 and 1974 the value of manufactured exports increased almost four-fold and their share in total merchandise exports increased from 20 percent at the end of the 1960's to over 40 percent in From 1974 on, the worsening exchange relationship affected exports and in 1976 these were 20 percent below their 1974 level in real terms. The massive peso devaluations at the end of 1976 and beginning of 1977 restored competitiveness to Mexican manufactured exports, and by 1978 exports exceeded the 1974 peak by about 10 percent in constant terms. Despite the prospects of large export earnings from oil, the Government proposes to continue promoting the export of manufactured goods,avoiding an overdependence on hydrocarbons. Industrial Development Strategy 29. The Government announced in March of 1979 a new long term program to develop industry. Its general objective is to expand employment opportunities so as to provide a minimum level of income and comfort to the bulk of the population. To this end, the industrial development strategy would (i) emphasize the production of basic consumption goods required by the majority of the population, (ii) develop priority subsectors to increase exports and substitute imports efficiently, (iii) develop lines of industry which process domestic primary materials or provide needed inputs - such as machinery and equipment - for other branches of industry, (iv) decentralize economic activity by encouraging investments in coastal, border and other regions, and (v) reduce concentration of industrial ownership by promoting medium and small scale industries.

14 Public sector investments in oil, power, primary petrochemicals, transport and other subsectors, would provide the main thrust of an industrial and economic expansion. The private sector would participate by providing many of the inputs required for the expansion of public sector enterprises - including capital goods - and would benefit from energy and petrochemical inputs at favorable prices to produce goods for the domestic and export markets. It is visualized that, besides being the most important means of transforming export earnings from hydrocarbon sales into increased employment and income for a significant proportion of the population, the industrial sector would gradually bolster foreign exchange earnings through expanded exports. 31. The package of measures adopted in support of this strategy include both direct measures which would be taken by the Government itself and incentives for the private sector to invest. They consist of: (i) programmed investments by the Government and public sector enterprises in important sectors of the economy, (ii) subsidized energy and some industrial inputs for certain industries in areas of high priority (paras ), (iii) fiscal incentives, (iv) credit, and (v) the rationalized tariff structure mentioned in paragraph 27 above. The package of benefits gives clear preference to new enterprises located in priority geographic regions and to small scale enterprises. Small Scale Enterprises 32. While recognizing that larger enterprises have played, and are likely to continue to play, an important role in industrial development by introducing technological improvements and developing foreign markets, the authorities wish to increase competition and pay special attention to the needs of medium and small scale enterprises. The latter, in particular, are considered to require special attention because they are more vulnerable to market fluctuations, have limited access to credit and frequently suffer from management problems, while providing a higher level of employment per peso invested than larger enterprises. For these reasons the authorities introduced the fiscal incentives for small scale enterprises mentioned in paragraph 36 below. Measures in Support of the Industrial Development Strategy 33. Public sector enterprises already play an important role in key sectors of the economy, in particular in the fields of energy, basic petrochemicals, steel and fertilizers. The procurement programs of such enterprises will be made known in advance so that national producers of capital goods can gear their production programs to meet them. Procurement guidelines were devised in 1978 by which national producers of capital goods are favored, provided their offers are within the price prevailing in major capital goods producing countries and transport costs to Mexico, plus 15 percent. The duty exemption which was granted to public sector enterprises on capital goods imports will be abolished.

15 Under the announced strategy, Mexico has been divided into areas of high, medium and low priority for purposes of industrial development. Four port areas have been given high priority (Coatzacoalcos and Tampico on the Gulf Coast and Lazaro Cardenas and Salina Cruz on the Pacific Coast) with some additional cities which are also considered of high priority. In the second group, specific areas which State and Federal authorities might designate for special promotion will be included. The third group will include areas in which industrial growth is to be regulated strictly; Mexico City and adjacent municipalities form part of the low priority areas. The Government will undertake substantial investments in physical and social infrastructure in high priority areas, and public sector enterprises will carry out a number of their investment projects in them. These measures, as well as the investments which the private sector may make in response to incentives, should enable the achievement of a critical mass of industrial activity in each area, and of external economies which should attract yet more investment. 35. In addition, natural gas, fuel oil and power will be sold at 30 percent less than in the rest of the country in the four industrial ports mentioned above,provided such inputs are used by new production facilities. Moreover, primary petrochemicals will be sold at a 30 percent discount to new enterprises located in the priority areas if they produce specified secondary petrochemicals and export at least 25 percent of their production in three years. 36. The above measures will be complemented by new fiscal incentives introduced in early 1979 which are designed to create employment by stimulating investment and the domestic production of inputs. The value of the incentives--which will be granted as tax credits-- will depend on the geographic location of the project, the size of the enterprise carrying it out, the priority of the industrial activity it is engaged in, the volume of employment generated and the value of domestic equipment purchased. For instance, enterprises engaged in priority industrial activities (i.e., agroindustries, the manufacture of capital goods and some designated consumer and intermediate products) which intend to locate their facilities in geographic areas of high priority, would receive a tax credit equivalent to 20 percent of their fixed assets and a further tax credit equivalent to 20 percent of the wage bill resulting from new employment during a period of two years. The value of these credits is somewhat lower if high priority industries are located in geographic areas of intermediate priority. In addition to these incentives, a 5 percent tax credit will be granted for the purchase of domestic capital goods, regardless of where the industry is located or the industrial activity engaged in. A credit equivalent to 20 percent of the wage bill for two years resulting from the employment of additional shifts is also offered, except to enterprises located in Mexico City. Lastly, enterprises designated as "small" 1/ would receive a 25 percent credit on the value of their investment, regardless of their location or the industrial activity they are engaged in. 1/ With fixed assets equivalent to less than 200 times the yearly minimum wage in the Federal District, or about US$430,000 equivalent.

16 The availability of credit on appropriate terms, which is discussed in paras. 38 to 41, completes the package of measures adopted to promote industrialization. This gives clearer signals on subsectoral and geopraphic priorities than has been provided in the past. The strategy for industrial expansion makes a bold attempt to overcome the challenge presented by Mexico's rapidly expanding labor force by encouraging the domestic private sector to supply an important proportion of the inputs needed for investments in the public sector, thus creating job opportunities in industries, such as capital goods, which are more labor intensive than the sectors the Government has been investing in. The Financial System 38. Mexico's banking system, comprising more than 200 public, private and mixed ownership institutions, has been the primary source of financing for industry. Commercial banks and investment banks (financieras) make industrial loans and investments primarily from resources they mobilize in the private sector via current accounts, deposits, and the issue of certificates and bonds, but they also have access to discounting facilities with public sector trust funds. During the late 1960s and early 1970s, the banking system grew rapidly and the volume of outstanding credit grew faster than GDP. Mexico's open financial system allowed a free flow of capital, and the long period of exchange rate stability encouraged foreign deposits in Mexican banks and foreign borrowings by Mexican firms. Credit was readily obtained by industrial firms judged to be a reasonable credit risk. Nevertheless, certain structural weaknesses were apparent by the early 1970s. One was an excessive conservatism in credit allocation. Guarantees in excess of the legal minimum (133 percent of credit granted) were required, and even credit for projects requiring term financing was decided primarily on the basis of the collaterals offered, rather than on the basis of appraisals of the merits and income earning characteristics of investment projects. The excessively short-term structure of the banking system's non-monetary liabilities resulted from, among other things, insufficient interest rate premiums to savers for longer term deposits. This limited the amount of longer term financing that banks could provide. 39. To improve the amount and nature of credit available to industry, the financial authorities developed a system of trust funds, which provide partial financing to banks for term loans for projects meeting eligibility requirements. Trust funds are in two groups; Nacional Financiera, S.A. administers three which are designed to support mainly the development of small and medium scale industry, while the Banco de Mexico administers two other closely related trust funds: Fondo de Equipamiento Industrial (FONEI) and Fondo de Fomento a las Exportaciones de Productos Manufacturados (FOMEX). FONEI provides medium and long term financing for investment projects designed to increase exports or efficiently substitute imports, and FOMEX provides shorter term export sales financing and has recently been given additional resources to finance the sale of domestic capital goods to Mexican buyers. FONEI, which has received three previous Bank loans, will be the executing agency for the proposed project. A Bank loan to assist small and medium industry through the trust funds administered by Nacional Financiera was approved by the Executive Directors in FY 78.

17 The financial crisis experienced in when the public made massive withdrawals of funds from the banking system, convinced the authorities of the urgent need to strengthen the sector. In December 1978 the Government passed a series of amendments and additions to the Banking law which were the most substantial since the original law was enacted in Several amendments encourage the grouping of specialized banks into full service multibanks. This is expected to raise the efficiency of the system by lowering administrative costs through economies of scale, by improving access to clients outside the bigger cities to a full range of financial services, and by improving the financial base of smaller banks enabling them to compete better. Several multibanks have already been formed and the trend towards them seems to be firmly established. The amendments also eliminate the requirement that loans must have minimum collateral of 133 percent, establishing that loans may be granted on the economic feasibility of the business undertaking and that repayment terms should be set on the basis of a project's expected cash flow. These principles have been promoted by FONEI since it started operations in To boost domestic savings, improve the term structure of bank liabilities and reverse capital flight, the authorities raised interest rate ceilings on time deposits in late These higher interest rates and the renewed confidence of savers in the country's economic management, helped increase the non-monetary liabilities of the financial system from 19 percent of GDP in 1977 to 21 percent in The authorities have stated their intention of continuing to review the structure of interest rates to ensure a healthy growth in financial savings. Financial institutions have been increasingly adopting variable interest rates for longer term lending operations since The change from fixed interest rates, which had been used in the past, came after an acceleration of inflation in By 1977, practically all term loans were made at variable interest rates linked to the average cost of funds (ACF) to financieras and investment banking departments. This is the weighted average interest rate paid on bonds, notes and certificates of deposit, and excludes checking and savings deposits. Between the last quarter of 1977 and January 1979 the ACF increased from 14.3 percent to percent. Banks charge their clients a premium over the ACF base which varies depending on compensating balances maintained by clients, other business done by the borrower, and risk. At the present time, the cost of term funds fluctuates between 18 and 23 percent yearly. The Securities Market 42. The securities market had not been an important source of financing for industrial enterprises in Mexico up to recently. Firms were reluctant to sell shares to the public to avoid disclosure of information and for fear of losing control. Investors, on the other hand, found shares less attractive than fixed return securities, many of which were guaranteed redemption at par. The authorities carried out a number of reforms in aimed at strengthening the securities market; these included the consolidation of two regional security markets into the main one in Mexico City, better regulation of brokerage firms and measures to speed up security transfers. The tax treatment of profits and losses resulting from stock ownership was also improved. These measures, and the abolition in 1977 of

18 fixed interest securities which were redeemable on sight, have had positive results on stock trading, which increased from Mex$5.8 billion in 1977 to Mex$30.3 billion in 1978, with industrial shares accounting for almost two-thirds of turnover in the latter year. Twenty five new stock placements took place in a record number - and ten debenture issues were made. The securities price index also rose significantly during 1978 reflecting interest in securities which offer a better hedge against inflation and rising expectations of profitability in industry. The measures taken by the authorities should make the securities market a more significant source of investment funds for industry in the future. The Outlook for the Future 43. The industrial sector is showing a strong recovery from the recession it experienced in the mid-1970's and investment is taking place at a rapid pace. The economic development strategy outlined by the Government for the medium term gives the industrial sector a pivotal role in generating employment and prosperity, and the private sector will have an important role in this scheme. However, the financial system has not yet developed sufficiently to provide and allocate long-term resources in the most effective manner. In this situation, the trust funds managed by the Government have an important role to play by supplementing and guiding credit provided by the financial system. The proposed Bank loan to FONEI through NAFINSA would help strengthen the financial system during a critical period of its evolution and, when taken with the Small and Medium Scale Industry Development Project Loan of May 1978, would round off Bank support for the sector. PART IV - THE PROJECT 44. The proposed project would support FONEI's policies and therefore: (a) help finance projects expected to have a substantial economic and employment impact, particularly those sponsored by medium size enterprises and enterprises located outside the main established industrial centers, (b) strengthen FONEI's efforts to build up project appraisal and project supervision capabilities in the participating intermediaries so as to improve resource allocation, and (c) introduce credit programs to help develop technology and finance industrial pollution control projects. The project would also help finance a training program on industrial project evaluation and supervision and a national study of human resources and technical and vocational training needs. A brief project description may be found in the Loan and Project Summary at the beginning of this report. The Staff Appraisal Report (Number 2473b-ME of May 10, 1979) entitled "Fourth Industrial Equipment Fund (FONEI) Project" is being distributed separately to the Executive Directors. The project was appraised in January/February 1979 and negotiations took place in Washington in May The Mexican negotiating team was headed by Mr. Arturo Ortiz of Nacional Financiera, as financial agent for the Government, and included Mr. Jesus Villasenior, Director of FONEI.

19 The Institution 45. The Bank participated actively with the Government in 1971 in the establishment of FONEI as a trust fund of the Federal Government administered by the Banco de Mexico. FONEI provides term financing through commercial banks and financieras to enterprises which produce goods and services for export markets or which substitute imports efficiently. In support of these objectives, the Bank made a US$35 million loan to FONEI in 1972, which is fully disbursed and a second, of US$50 million, in April 1976, which is totally committed. A third Bank Loan (1560-ME) of US$100 million, was approved by the Executive Directors in May 1978 and signed in September of that year. FONEI has already committed over eighty percent of it and expects to commit it fully by July or August FONEI's highest decision making body is its Technical Committee, which includes high level government officials. The Director of Public Credit of the Ministry of Finance is Chairman of the Committee, which takes an active interest in FONEI's activities. The Committee meets regularly and authorizes all financing proposals above Mex$15 million; decisions on credits below this amount are delegated to FONEI's Director to help speed up processing. The Banco de Mexico, as trustee, provides FONEI with the required staff, office facilities and administrative services. FONEI has a streamlined administration with relatively low administrative costs. Its staff is well qualified, competent and dedicated. Operating Policies and Procedures 47. FONEI's Operating Regulations define the type of project that it may finance, the terms and limits of subloans, its interest rate policies, criteria for project selection, the responsibilities of intermediaries and final beneficiaries and procedures to authorize financing. By terms of previous Bank loans and of the proposed loan (Section 2.01(c) of the Draft Project Agreement) Banco de Mexico (BANXICO), FONEI's trustee, will consult the Bank before any changes in the Operating Regulations are made. The Operating Regulations specify that, in selecting projects for financing, FONEI will consider inter alia the following criteria: (i) the project's economic rate of return, (ii) the project's foreign exchange generating or savings potential, (iii) its employment impact, and (iv) its industrial decentralization aspects. The maximum amount of financing which FONEI can provide to a single project is normally Mex$100 million and the minimum is Mex$4.5 million, which matches the upper limit of investment financing provided by FOGAIN, the trust fund managed by Nacional Financiera which participates in the Small and Medium Scale Industry Development Project being financed by the Bank. FONEI's subloans have a maximum maturity of 13 years, including three years of grace. 48. FONEI requires that financial intermediaries and beneficiary enterprises participate in the financing of projects. Final borrowers are required to finance at least 25 percent of the fixed asset costs of new projects and 20 percent in the case of expansion projects. Intermediaries are required to provide at least 15 percent of FONEI's financing for new projects, which in turn is limited to 65 percent of project costs, and 11 percent in the case of expansion projects, where FONEI could provide up to 72 percent of project costs. On the average, FONEI financed about 40 percent of project costs.

20 FONEI has successfully introduced the use of variable interest rates based on the ACF index in all its operations. The cost of FONEI funds to final borrowers is two percentage points above the ACF, which in January of 1979 stood at percent, resulting in a cost to final borrowers of percent per annum (see paragraph 41). This is reasonable compared to the rate of inflation, which decreased from 29 percent in 1977 to 18 percent in 1978; the Government intends to reduce the rate of inflation to international levels by In the event that inflation should increase, the ACF should be a suitable base for determining FONEI's lending rate in view of the Government's announced intention of maintaining borrowing interest rate levels which permit an adequate resource flow into the financial system. 50. At the time FONEI was established, few, if any, financial intermediaries had developed capabilities to carry out detailed project appraisals or to supervise projects in execution. Decision on loans were largely based on collateral offered. FONEI took upon itself the responsibility of evaluating projects with its own staff and/or consultants, while encouraging intermediaries to develop their own project appraisal capabilities. Mainly because the number of operations per intermediary has been comparatively small, intermediaries have not yet advanced much in developing their project appraisal capabilities. In the context of the third Bank loan, FONEI decided to allow interest rate spreads in addition to the normal two points margin to intermediaries undertaking project appraisals (0.5 percent for loans of up to Mex$30 million, and 0.25 percent for amounts above this). To facilitate the preparation of detailed appraisals, FONEI also encouraged client companies to undertake feasibility studies using FONEI subloans. As a result of these measures, more projects are now being analyzed by intermediaries and it is expected that those which make greater use of FONEI funds will be able to maintain small appraisal units. FONEI is also considering added margins to induce intermediaries to undertake full project supervision, thus assuring fuller utilization of the units assigned to investment banking. While these changes take place, FONEI will continue to carry out project appraisals itself with the help of consultants. Its appraisals are of good quality and include an adequate analysis of the organizational, marketing, technical, financial and economic aspects of projects. In recognition of this,fonei's free limit for committing Bank resources for operations other than those involving technology, pollution control and service export subprojects would be increased from US$1.5 million to US$2.0 million (Section 2.02(b) of the Draft Loan Agreement). This will enable the Bank to review about 40 percent of the subprojects involving ordinary operations and about 60 percent of the loan amount. Past Operations and Impact 51. As of year-end 1978, FONEI had financed a total of 142 investment projects involving Mex$ billion in total costs and Mex$5.1 billion in FONEI financing. About half of the financing provided by FONEI went to industries producing metal and electrical products, including a substantial number of capital goods industries, which are of high priority to the Government. Chemicals and petrochemicals industries accounted for about a quarter of FONEI's loans, while other manufacturing activities accounted for the bulk of the remaining loans; service activities only accounted for 3 percent of total approvals.

21 Projects financed by FONEI have had a positive balance of payments impact. Of the total number of projects financed, about 30 percent were projected to earn at least enough foreign exchange in the first five years of operations to cover the foreign exchange cost of the project. About another 28 percent involved some exports, while the remaining 42 percent substituted imports only. An ex-post evaluation by Bank staff in 1978, showed that a sample of enterprises financed by FONEI under the first two Bank loans had performed well in exporting and substituting imports efficiently relative to the projections they had presented during appraisal. 53. FONEI has made an important contribution to the Government's policy of decentralizing industrial activity. Projects located in the three main urban concentrations and established centers of industry - Mexico City, Guadalajara and Monterrey - accounted for only 38 percent of the total number of projects and 28 percent of the financing provided to year-end This compares favorably with the performance of the banking system as a whole, which is estimated to channel over 80 percent of its financing to activities in these areas. 54. Projects financed by FONEI have had a positive effect on employment. The average cost per direct job created in all projects financed by FONEI to date was projected to be US$29,600 equivalent, which compares well to the employment impact of medium and large scale industry in countries of similar stage of development. Ex-post analysis of a sample of enterprises showed a favorable employment creation impact relative to the projections considered by FONEI at the time of its appraisal; the actual number of jobs created was 15 percent above expectations. 55. FONEI has followed a policy of distributing its resources as widely as possible among industrial clients in Mexico. As of January 1979, no single industrial group had received more than 9 percent of the total value of loans granted by FONEI and its five largest client groups accounted for 35 percent of its total lending, which is not an unreasonably large proportion considering the ownership distribution of Mexican industry and the tendency of financial intermediaries--who carry the credit risk--to favor better established enterprises. However, to make FONEI's policy of favoring medium size enterprises more explicit and to insure that the distribution of its resources is as wide as possible among industrial firms, FONEI's management intends to alter its Operating Regulations to establish a normal cumulative limit of Mex$300 million for loans to a single enterprise. As an incentive for intermediaries to lend to medium rather than large enterprises, it plans to grant an additional interest rate spread or margin (of about 0.25 percent) for loans to enterprises with an equity capital of less than Mex$50 million. The amendment of FONEI's Operating Regulations to this effect in a manner satisfactory to the Bank, and the introduction of appropriate regulations for technology and pollution control subloans, would be a condition of effectiveness of the proposed loan (Section 6.01 of the Draft Loan Agreement). 56. The economic rate of return on projects financed by FONEI has been satisfactory. The bulk of them had ex-ante economic rates of return of more than 15 percent in real terms, with the weighted average being about 28 percent. Financial rates of return, although somewhat lower, were also satisfactory, with a majority having returns above 15 percent. Though

22 for practical reasons it has not been possible to calculate ex-post economic and financial rates of return, there is reason to believe that they were close to expectations since most subprojects are being carried out successfully, with actual output, exports and employment exceeding expectations. Financial Structure and Results 57. The Government made an initial equity contribution of Mex$125 million to FONEI when it was created in By terms of the first and subsequent loan agreements with the Bank, the Government agreed to take the foreign exchange risk on Bank loans and to repay them, increasing FONEI's capital as repayments are made to the Bank. FONEI, however, takes on the foreign exchange risk on interest and other charges on Bank loans. To complement Bank resources and finance the local cost of subprojects, the Government has provided FONEI with Mex$2.5 billion, mostly in the form of long-term loans at concessionary interest rates. Since FONEI is a secondtier credit institution the credit risk on its operations are negligible. In view of the arrangements made by the Government to capitalize FONEI, and of the low risk inherent in its loans, FONEI's financial position can be considered sound. 58. Because FONEI took the foreign exchange risk on interest and other charges on Bank loans while its lending rates were fixed in pesos, it experienced operating losses in 1976 and 1977, after the devaluation. Since the adoption of a variable lending interest rate, its operations have become profitable, and in 1978 it earned a surplus of Mex$11 million. With the growth of its lending volume, FONEI's administrative expenses have declined considerably, from 2.9 percent on average total assets in 1974 to 0.91 percent in FONEI is an efficiently run institution. 59. FONEI's accounts are audited in a form acceptable to the Bank by a reputable Mexican auditing firm. All audit reports on FONEI's accounts have been unqualified. Future Operations 60. With the prospect of growing demand for investment credit over the next two years as a result of renewed confidence in the private sector and the Government's clear guidelines for future industrialization, FONEI anticipates a substantial increase in resource needs. It also intends to initiate two new programs to help resolve critical aspects of industrialization in Mexico: one to help finance technology improvement projects and the other to finance investments in industry to control pollution. 61. Technology improvement will become increasingly important in the future to Mexican industry, which has reached a relatively high degree of sophistication and has a substantial pool of well developed engineering and technical staff. To increase further domestic value added and compete effectively in world markets, there is a need to stimulate the development of new or improved products, more efficient production methods and new technologies to exploit available raw materials efficiently. Though the Government has taken several steps to encourage technological improvements, there

23 are few opportunities in Mexico for enterprises to finance technology projects. FONEI intends to fill this gap by offering a limited amount of medium and long term credit with interest charges at three percentage points below the ACF; this differential is justified in view of the high risk associated with individual technology development projects and of the broad benefits to Mexican industry of the program as a whole. 62. Industrial pollution, coupled with pollution caused by an extremely rapid growth of vehicular traffic, has become a serious problem in almost all industrial areas of Mexico. Legislation has been enacted since 1971 to prevent and control environmental pollution and more is in preparation. In support of this legislation, FONEI intends to offer credit to firms which wish to meet the standards of the legislation and require industrial pollution control equipment and technical assistance in the design and/or selection of such equipment. Loans granted for pollution control projects would be made at an interest rate of between two points above and three points below the ACF. FONEI intends to start offering credit for this purpose at the interest rate for its normal operation (i.e. two points above the ACF) but would be prepared to lower it for plants established before the legislation was enacted if demand is slack. Eligible investments would not normally add to the production capacity of enterprises but would benefit the population at large, so an element of subsidy in such financing is justified. Resource Requirements and the Proposed Bank Loan 63. FONEI is currently facing strong demand for investment financing. Loan recoveries and profits from operations, as well as a US$105 million equivalent loan from BANXICO (Section 2.01(b) of the Draft Project Agreement), would provide it with resources of about US$138 million equivalent to finance operations for about two years. The proposed loan of US$173 million equivalent would enable it to finance the foreign cost of subprojects representing investments of over US$700 million equivalent. 64. The proposed Bank loan would be made to NAFINSA, as financial agent for the Government, and up to US$2.0 million would be available to help finance the cost of studies to assess the human resources and technical and vocational training needs for industry in the light of the Government's industrial development strategy. These studies would be coordinated by the Ministry of Education and the Bank would review the terms of reference. 65. Not less than US$173 million of the loan would be transferred to BANXICO, as trustee responsible for managing FONEI. Of this amount, up to US$5 million each would initially be allocated to technology improvement and pollution control subprojects; should actual demand exceed expectations, the Bank would be prepared to consider increasing these allocations. Not more than US$10 million would be available to finance service export projects. Up to US$250,000 would be available to finance training activities related to FONEI's program to build up project appraisal and supervision capabilities in participating institutions. As in previous Bank loans, the Government would carry the foreign exchange risk on the loan amount and undertake to repay the principal to the Bank. It is proposed that the Bank loan be repaid over 17 years, including four of grace.

24 To obtain a reasonably wide distribution of Bank funds, not more than US$5 million would be onlent for a single subproject (Section 2.02(c) of the Draft Loan Agreement). Since the technology and pollution control programs are new, the Bank would review the first three subprojects of each kind and the free limit thereafter would be lower than for FONEI's ordinary operations: US$500,000 in the case of technology subprojects and US$750,000 in the case of pollution control subprojects. As in the case of the previous loan to FONEI, all service export subproject (e.g. repair services in border areas) would be subject to prior approval by the Bank (Section 2.02(b) of the Draft Loan Agreement). Procurement and Disbursement 67. Procurement procedures for goods and services financed under the proposed loan would be the standard ones for industrial credit operations. FONEI would be responsible for ensuring the competitiveness of items procured in terms of price and quality, and their suitability for the purposes intended. 68. Disbursement of Bank loan funds would be on the following basis: 100 percent of foreign expenditures for directly imported items; 70 percent of total expenditures for imported items purchased off-the-shelf in Mexico; 25 percent of total expenditures for domestically manufactured machinery and equipment and the cost of installation and industrial construction; 40 percent of total expenditures for technology subprojects and 50 percent of total expenditures for training activities. The above percentages represent the estimated average foreign exchange cost. The disbursement percentage for the human resources studies would be 47 percent. The foreign exchange cost of these could vary considerably depending on the extent to which foreign consultants are used; the percentage represents a rough estimate of the foreign component of the studies and is the same as recently approved for studies in a Highway Sector Loan to Mexico. Benefits and Risks 69. The proposed project is expected to have an important institutional development impact in assisting FONEI to improve the project appraisal and supervision capabilities of financial intermediaries in Mexico. This would contribute to the Government's goal of improving resource allocation by the financial system and help give support to the more dynamic activities in the industrial sector. The proposed loan would also give financial assistance to firms sponsoring high priority subprojects in the industrial and related fields not served by the Small and Medium Scale Industry Development Project, for which a Bank loan was granted in FY78. Based on past experience, around 150 subprojects would be financed under the proposed loan and their employment, industrial decentralization and economic impact can be expected to be significant. 70. As FONEI is evolving into a reasonably efficient and mature financial institution, the project presents no special risk with respect to the soundness of the projects it would finance. The institutional goals are more difficult

25 to achieve over the short run; however, the combination of policies embodied in the new banking law, FONEI's new system of varied spreads to intermediaries and its promotional efforts, as well as the training program which would be undertaken under the project, greatly increase the chances of success in the near future. The Government's new incentive scheme for industry will promote its employment, export and industrial decentralization goals and improve the prospects of sustained industrial development. On the whole, the project presents a moderate level of risk. PART V - LEGAL INSTRUMENTS AND AUTHORITY 71. The draft Loan Agreement between the Bank and NAFINSA, the draft Guarantee Agreement between the United Mexican States and the Bank, the draft Project Agreement between the Bank and Banco de Mexico, and the Report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement are being distributed to the Executive Directors separately. Special conditions of the project are listed in Section III of Annex III. A condition of effectiveness would be that FONEI's Operating Regulations be amended in a manner satisfactory to the Bank (para. 55). 72. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 73. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments May 15, 1979 by I.P.M. Cargill

26 ANNEX I Page 1 of 5 TABLE 3A MEXICO - SOCIAL INDICATORS DATA SHEET REFERENCE GROUPS (ADJUSTED AVERAGES LAND AREA (THOUSAND SQ. KM.) MEXICO - MOST RECENT ESTIMATE) / TOTAL SAME SAME NEXT HIGHER AGRICULTURAL MOST RECENT GEOGRAPHIC INCOME INCOME 1960 Lb 1970 /b ESTIMATE /b REGION /c GROUP /d GROUP /e GNP PER CAPITA (US$) ID ENERGY CONSUMPTION PER CAPITA (KILOGRAMS OF COAL EQUIVALENT) POPULATION AND VITAL STATISTICS TOTAL POPULATION, MID-YEAR (MILLIONS) URBAN POPULATION (PERCENT OF TOTAL) POPULATION DENSITY PER SQ. KM PER SQ. KM. AGRICULTURAL LAND POPULATION AGE STRUCTURE (PERCENT) 0-14 YRS YRS YRS. AND ABOVE POPULATION GROWTH RATE (PERCENT) TOTAL URBAN CRUDE BIRTH RATE (PER THOUSAND) CRUDE DEATH RATE (PER THOUSAND) GROSS REPRODUCTION RATE FAMILY PLANNING ACCEPTORS, ANNUAL (THOUSANDS) USERS (PERCENT OF MARRIED WOMEN) FOOD AND NUTRITION INDEX OF FOOD PRODUCTION PER CAPITA ( ) PER CAPITA SUPPLY OF CALORIES (PERCENT OF REQUIREMENTS) PROTEINS (GRAMS PER DAY) OF WHICH ANIMAL AND PULSE /f CHILD (AGES 1-4) MORTALITY RATE HEALTH LIFE EXPECTANCY AT BIRTH (YEARS) INFANT MORTALITY RATE (PER THOUSAND) ACCESS TO SAFE WATER (PERCENT OF POPULATION) TOTAL URBAN * RURAL ACCESS TO EXCRETA DISPOSAL (PERCENT OF POPULATION) TOTAL URBAN RURAL * POPULATION PER PHYSICIAN POPULATION PER NURSING PERSON / /h POPULATION PER HOSPITAL BED TOTAL URBAN RURAL /i ADMISSIONS PER HOSPITAL BED HOUSING AVERAGE SIZE OF HOUSEHOLD TOTAL * URBAN RURAL AVERAGE NUMBER OF PERSONS PER ROOM TOTAL URBAN RURAL ACCESS TO ELECTRICITY (PERCENT OF DWELLINGS) TOTAL URBAN RURAL

27 A15NNEX I Page 2 of 5 TABLE 3A llexico - SOCIAL INDICATORS DATA SHEET REFERENCE GROUPS (ADJUSTED AVERAGES MEXICO /a - MOST RECENT ESTIMATE) SAME SAME NEXT HIGHER MOST RECENT GEOGRAPHIC INCOME INCOME 1960 Lb 1970 Lb ESTIMATE Lb REGION /c GROUP 1d GROUP /e EDUCATION ADJUSTED ENROLLMENT RATIOS PRIMARY: TOTAL FEMALE SECONDARY: TOTAL FEMALE VOCATIONAL (PERCENT OF SECONDARY) PUPIL-TEACHER RATIO PRIMARY SECONDARY ADULT LITERACY RATE (PERCENT) CONSUMPTION PASSENGER CARS PER THOUSAND POPULATION RADIO RECEIVERS PER THOUSAND POPULATION TV RECEIVERS PER THOUSAND POPULATION NEWSPAPER ("DAILY GENERAL INTEREST") CIRCULATION PER THOUSAND POPULATION CINEMA ANNUAL ATTENDANCE PER CAPITA EMPLOYMENT TOTAL LABOR FORCE (THOUSANDS) FEMALE (PERCENT) AGRICULTURE (PERCENT) INDUSTRY (PERCENT) PARTICIPATION RATE (PERCENT) TOTAL MALE FEMALE ECONOMIC DEPENDENCY RATIO INCOME DISTRIBUTION PERCENT OF PRIVATE INCOME RECEIVED BY HIGHEST 5 PERCENT OF HOUSEHOLDS 28.7 /h HIGHEST 20 PERCENT OF HOUSEHOLDS 58.8 /h LOWEST 20 PERCENT OF HOUSEHOLDS 3.5 /ih LOWEST 40 PERCENT OF HOUSEHOLDS 10.3 Ah POVERTY TARGET GROUPS ESTIMATED ABSOLUTE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN RURAL ESTIMATED RELATIVE POVERTY INCOKE LEVEL (US$ PER CAPITA) URBAN RURAL ESTIMATED POPULATION BELOW POVERTY INCOME LEVEL (PERCENT) URBAN RURAL Not available Not applicable. NOTES /a The adjusted group averages for each indicator are population-weighted geometric mans, excluding the extreme values of the indicator and the most populated country in each group. Coverage of countries among the indicators depends on availability of data and is not uniform. /b Unless otherwise noted, data for 1960 refer to any year between 1959 and 1961; for 1970, between 1969 and 1971; and for Most Recent Estimate, between 1973 and /c Latin America & Caribbean; /d Intermediate Middle Income ($ per capita, 1976); le Upper Middle Income ($ per capita, 1976); /f Av ; /R Including midwifery and nursing auxilliaries; /h 1963; /i Data refer to rural health centers only. September, 1978

28 DEFfINITIONS OF SOCIAL INDICATORS ANNEX I Page 3 of 5 A lrr'ccgo dots ore rh drwn from ft generaly judged the mostauhrtiv and reliable. tsol,loh oe Otte a o ainr voinl"cspasl eas o h oho aederdieed definitions and -C-noPt. used by different onre ncletn the data. The data re ontbeleas. uoeful tc desribe ordoc of nagnitude, indirtot trends, and obera.ttriee eartein major differencestbetwano. contries.n Il-head (As Ld group ovearoee f.,or nau indicator are popul.tion-ve ighted geove tric eas emuluding tbe exrmevluso the indicator and the oa populaed cnrntru n eac gr,u. Tc'c'roge pf oontriaaogteidorr dpends on -vilability of dat so srtuifon.ifut ath of data. utouf OOvufettAr,aita Surplus All Sopor toreand Indicatrs facaet ae andnoreo aoa h,ovualug. income dietrihution and poverty are simple ouuir-egtdgennetric eans withot the -ocluion of entran.caal LAND AREA 'ttclanuuaudandinuad-waer).populatio Total -. I'ol turac aaournlgluarandnadwaeaurban, a hospita anpd'rural iie Ie ttl uban. and rural - Population (total, byttheir respective number of hospital beds Agiripkicolucl - tout rece"t eatiute uf agiculturol areas used tamporerily avilable In public and private general and sperilaifed boapital and inor... e... for op., postures, orket oud kitchen gardens or to hahtlitation centere. Hospitals are establishmente permanently staffed hy Ito follow, a~~~~~~~~~~~~~~t least one physician. Esteblisbments providing principally custodial tare. are nor included. Rural hospitals, howe.ver, include health and..di- NP CAITA(IS) fr - NS pot copita -utite at. current market price., cal centera not permanently ataffed by a physician (but by e medicalas cululaod y nve uuurolcc ue-hud eo Wurld Sank Atlos ( hels.i); ietaent, nremidwife, et-.) which uffer In-pti-et arcommodation and 1961, 1970, aud 1977 dotu. provide a limited range of medical facilitie.. Admiaona pr hoam'ita1 bed - Total numbe r of adminsiona to or dinuhargen ENERGY CONSUMPPTION PER CAPITA - Annual unusuptioss of comeercial energy from" hoptals, divided by the number o fbedo. (coal sod lignite, petroleum, natural gas sand bydro-, nuclear and geothermal electricity) in ksilograms of coal equivalent Par napit.. HOUSINGf Aeag si.e of household (persons per house.hold) - total, urban, and rural - POPULATION AND VITAL STATISTICS A b uushold coit of a group of individuala who obare liviog quarters Total population. mid-year millions) - as fjlab e avialein averae wo of ad-yea eatiates 1960, 1970, and 1977 data, hermimoe. A hoarder or lodger may or may not he included in the house.hold for otatlatical purpossa. itatistical definitions of house- Urban poultion (percent of total) - Ratio of urban to total popula- hold vary. to;different defionitons of urban areas map affect comaparability Average number of personpa pr room -totl, urban, and rural - Averge numof data among countries, ber of persona per r oom in all, urbat and rural occupied co-etiona I Population density dwellings, respectively. Dcelliog. esulude non-permanen t at ruotures and Per an. ha. - Mid-ysar population per square kilomater (100 hactare.) unoccupied parts. of total ores. Au cess to aleutricity (percent of delns total, urban, and rural - Per sq. ks.. ogri.uiture iand - Coaputed as above for arolcrlland Co-nv dotlooi dvellioge with electricity in living quertnerse p-eg only. of total, urban, and rural dwellingn reapectively. population aae structure (percen.t) - Children (0-li years), working-age (15-64 Years), und retired (65 years and over) as percentages of mid- EDUiCATION yea popoloticn. Adusted enrollinto ratios Populati on growth ran(percent, total, end urban - Compound annual Primary schoul - total' snd female - Total and female1 enrollment of.1 ages growth rutee of Eocl sd urban aid-year populations for , ttepiaylvla ecnoe irsetvl rmr tho-g 1965-Ti, sod ). ~~~~~~~populations; normlly includes children agedpb-il yesrbuthat djuted for Crudeirirt (Pe thousa.nd) - Annual live births par thousand of different lengths of primary education; for countri.xo wthuiversa duold-year pupulatioe; ten-year arithmetic averages ending ini1960 and cation enrolment may enceed 100 percent since cone. pupilu are below o 1070 sod five-yea average ending in 1975 for meat recent asetate, abov the official ochool uge. Crude doath rats(er thous..and) - Annual deaths per thousand of aid- isuondary school - total, and female - Computed as shoe;secondary educsyear populstion; ten-year arithmetic averages ending in 1960 end 1970 tion requires at least four years of approved primary Inatruccion; pro ond loe-ear verae eding in 1975 for meet recent estimae. idee general v-calune.., or teacher training Instructtions for pupils Itenrptdcto rate -Aeae number of daughters. oe ilha usually of 12 to 17 years of age; c-repondenee coursee are generally in her normal rproductive per iod If she Paeprienn.s present age- eoluded..peciffo teri ity erns.; usualily five-year averges ending Io 196f, Voslna nol lmnt,put o eoday - cuosiitnton l- 1970, usd clods technical, indus.tirial, or othr Programs which operate independently Fonllo panriog - acceptors, annua (thousands) - Annual number of or ase departoeot of secondary institution.. ac ceptors of hitch-con.trol devicesunder auspio.s of national fenily PupIl-teachen,r:ratio - primary. and eecondary - Totul students enrolled in pianoing program. p~~~~~~~~~rimry adscndary levels divided hy numbers of teachers in the corre- Family Planning - usrs (Percent of married women.) - Peru...taga of -Pndgiveo married coe of child-hearing egg (15-44 years) who use birtb-control Adul t literacy rate (percent) - Literats adults (able to read sod write) a devices to' uimaried women in same age group. ercentage of total adult population aged 15 years and over. roil AN0i1 NUTRITION CONSUMPTION loden of fod peodruction per capita ( ) - Inden nuber of per PIesnanercaret(per thousand population) - Pasenger. c--ars oomprise moto%r crn capita anua pr,oduction of all food oomoditias. seating.ems than eight persons; emcludes ambulanceo, hearses an dmiior per capita supply of calo.ries (Poroent of resuirseents) - Computed fro vehicles. energy equivalet cf net food supplies available in country per cpita gadic receivers (per thousand population) - All typee of receiv-r for radio per ds. Avuilable aupplies comprise domestic poduction, imports lees hrudcst to general public per thousand of population; encludes unlicensed esporte, and thanges in stock. Nist supplies exclude animal feed, seeds, receivers in co..uniree and in years wheo registration of radio sets eus in quantilteeosn d in food prosig,so L.sa i distribution. R.- offect; dots for roen.t ysa.r may not.eooporsble sinc moan coutnrio quiceme,tt were ostieatnd by PAO base.d on physiological needs for nor- sbuliuhed licens.ing. ml o-tlolty und healtit coo..idering environmental temperature, body TV reeivers (per thousan.d popuistion) - TV tcnciveru for br-dcat tc genert1 weightn, ogetcod sep diotnibutione of population, and allowing ii per- publico per1 cho.oandwpopulstioo; encde unlicensed TV receivers in cu-- cotfocan athousehold levei. tries ond in yesre whergitaonftvsscn too,effect. Petcait sply of protein (urn Per day) - Protein content of pernwaor ciulto(pen,rithouand pouaion) - ihowothef average circoii-- capit ce su.pply of food Pe r day. Nanspply of food is defined s tino of "daily general interest newpaper", defined s periodicoi publiabov.- Requleemneot for all coun.tri.:esetablisey. b A pruvide foe cation devtdpiaiyt erriggnrlnw. it is cnuidce cv o ininu allowanc 1 of A0Stgrms or tonal prtin per day and 210 gr.n. be "diy fi per tistfu ineu k. of animali and pulse protein, of which ii grams should he animal protein. Cioema annual attendance par uspita per year - Base d on cie nuhnr of tickets Obese orndards ore lower than thofte of 75 grns of total protein n.oddrn h er nldn disost rv-ncnnsudohl 23 grm of anima1 protein as an average for the world, propose.d by units A00 Ic the Third World Pod gurney. rpcaltu proteo supply from animal aud pulse - Protein supply of food EMiPLOYMENT derived fro anml nd pls:en i gram pe a.total labor force (thousands) -fc-nvnlclly a.ttl- persons, ioc1uding armed Chil (aes. 1-A) mortalt rae(e huand) - Annual deaths par thous- for.o o,n-d_uonplo~yed but enludlug houecives, students, etc. leftinftnd in age grcop 1-A -cearo to children in this.ag group. ttoe n vaious uouotrien7 orenot 0eprble.. feae(pret - F.oele lobor force as p.percentge of total lobor force. H10LT9 Agiutur (percet)- Labor force in forming, forentry, hunting and fishiog Life eupec atunyat hirth (years) - Average number of years of life aft percentage of total labor force reminisg ut bi rt h; usualy five-year averages ending in , Industry (percent) - Labor forte in mining, construction, m-ofucturiog and and electricity, estr.sod gas as percentage of totei labor forco. Inototul'Ly rtate (per thnuoendl Annual deaths of infants under Particinatio-ae(ecn)-ttl ae,cdfnl nu,nb n oni ee f agserh_ounnd livebirhts. female lohb. ore fopercnae ohi esetv opltos Acc-a to o_ufe este (percent of poulation -total, urban, and rurali - These are ItO's adjusted purtipripni ratet, reflecting av-se Number of people (ttr, urban, and rurel) wit h rassonabe a ccess to strour of the "oootc.n long 'i-p -red. -ufe outer supply (includesceoa oufc atersr nltfesated hut tocunic de~pend e-c rti Ratio of populti-r under 15 ar 65 and voerco urcncairuted water such a that fr.e Protected horeholee, aptings, the labor force in age grcup f out und-nootary cello) on p-oercstgeo of their res pective populations. So, onurbo area!apbi ountain or standpoet located not more INCOME DlISTIBitTION iron 201 meters ffromua house may he considered as haing vithtn re.- Peecnaeo,rot noe(ohipcu n id eevds-ihs console access of that bousee. In rurl are. as ee.ablnel access would percnt. richant 2i percpnt. pcoe_t 25 Perco,_ und ocreu..t pervert laply chat rho housecife or mombers of the house hold do not have to of househotdn. spendl u diuproportiopute part of the day in fenoling the family's color Irdu. Access cc eoorota disposai (percent of population) - total. urban. and POVERoY TARCET IROTfOS folited absolute poverty incom. ee.ts.e elt)--bt arc curd1 'coo'- Nucer fepol tta,uhn nd rsral) served by secrets Absolute poverty iboone 1levl Is thut ruelvl boson ohicsa'ii di,p Inlatpercertoge of ther repective popolatiens. foorter nutrlions... a1ydequato diet pi.. esuecou nor-food y uoo 0I u di,-.pal -oy loulude thep cuiectio n sd disposal, with or without affordable. un..c... c. vu.a.euceta and waste-water by water-borne systema E,is taed rear pvrty - too lve - (Ull per capita) -urhunuo.d rurl.- 22 A cut prioco- and nimilar installations. ieiati_e poverty iorne ovel lo fthat --om leve I..u thor ono-chir-d 1 -fuar- tcy-siolan - PopulatIon divided by nuber of practicing per us.pits pomon 1.. ircm f teonov. TOy- - q,.uuified fr,,n a medical schoc1atunivearsity level. issiosted populutionbeopvrtinmelel.rcc)-,cu lrra - ''ARL>ffl_kr.orogpsu - Populatiop dividedtby number of f Iccco populotuor, ) urbunan ruru.l).usc ore e hr"sultpo'a POOtl.ittcut par feru.le gruduae ureo procticain.r....nd "e topcor" oh ich_eriu roe fotvcud Soc cl U-La f-uvicfocuonta nulvoin udpretio outet