Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 28141-ME

MEMORANDUM OF THE PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND

THE INTERNATIONAL FINANCE CORPORATION

TO THE EXECUTIVE DIRECTORS

ON A

COUNTRY PARTNERSHIP STRATEGY OF THE WORLD BANK GROUP

WITH THE UNITED MEXICAN STATES

March 18,2004

Colombia and Mexico Country Management Unit Latin America and the Caribbean Region

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. I t s contents may not otherwise be disclosed without World Bank authorization.

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AAA AIDS BANOBRAS

BANRURAL BANSEFI CAA CAE CAS CFAA CFE CMU COMPRANET

CONACYT CONADEPI

CONAFE CONASUPO CONEWT CPAR CPPR CPS DDO ENRP ESSD ES W FARAC FOAEM FORTEM FOSEG FPSI FSL GDP GEF GNP HD HlV IADB IBRD

ICA ICB IDF IFAI IFC IMF I M S S INDESOL INEGI

IPAB ISSSTE

MEXICO-FISCAL YEAR January I-December 31

CURRENCY EQUIVALENTS (as of December 3 I, 2003)

Currency Unit = Peso 11.23 Pesos = US$l

WEIGHTS AND MEASURES Metric System

ABBREVIATIONS AND ACRONYMS

Analytical and Advisory Activities Acquired Immune Deficiency Syndrome Banco Nacional de Obras y Servicios Pdblicos, S.N.C. Banco Nacional de Credito Rural, S.N.C. Banco del Ahorro Nacional y Servicios Financieros Country AAA Assessment Country Assistance Evaluation Country Assistance Strategy Country Financial Accountability Assessment Comision Federal de Electricidad Country Management Unit Sistema Electronico de Contrataciones Gubemamentales Consejo Nacional de Ciencia y Tecnologia Consejo Nacional para el Desarrollo de 10s Pueblos Indigenas Consejo Nacional de Foment0 Educativo Compaiiia Nacional de Subsistencias Populares Consejo Nacional para la Vida y e l Trabajo Country Procurement Assessment Report Country Portfolio Performance Review Country Partnership Strategy Deferred Drawdown Options Environment and Natural Resources Program Environment & Social Sustainable Development Economic Sector Work Fideicomiso de Apoyo al Rescate de Autopistas Fondo de Apoyo a Estados y Municipios Programa para Fortalecer Estados y Municipios Fondo Nacional de Seguridad P~bl ica Financial, Private Sector and Infrastructure Fixed Spread Loan Gross Domestic Product Global Environment Facility Gross National Product Human Development Human Immunodeficiency Virus Inter-American Development Bank Intemational Bank for Reconstruction and Development Investment Climate Assessment Intemational Competitive Bidding Institutional Development Fund Instituto Federal de Acceso a la Informacion Intemational Finance Corporation Intemational Monetary Fund Instituto Mexican0 para la Seguridad Social Instituto Nacional de Solidaridad Instituto Nacional de Estadistica, Geografia e Informatica Instituto de Proteccion al Ahorro Bancario Instituto de Seguridad y Servicios Sociales de 10s Trabajadores del Estado

JICA LAC LIL MDA MDBs NAFIN NAFTA NCB NCSC NGO OECD

OED PCF PEC PEMEX PER PIDIREGAS PREM PROCAMPO PROCEDES PROGRESA PROFEPA PRONAFIDE PSBR R&D SAGARPA

SAL SCT SEDESOL SEMARNAT SENER SEP SFP SHCP SMEs SNG SOFOLES SRA SSA SSDS SWAP TA TAL TFP UN UNAM USAID VAT WBG WBI WPA WTO

Japan Intemational Cooperation Agency Latin America and Caribbean Region Leaming and Innovation Loan Master Derivative Agreement Multilateral Development Banks Nacional Financiera, S.N.C. North American Free Trade Agreement National Competitive Bidding National Commission of State Courts Nongovemmental organization Organization for Economic Cooperation and Development Operations Evaluation Department Prototype Carbon Fund Programa de Escuelas de Calidad Petroleos Mexicanos Public Expenditure Review Proyectos de Impact0 Diferido en el Registro del Gasto Poverty Reduction & Economic Management Programa de Apoyos Directos a l Campo Programa de Calidad, Equidad y Desarrollo en Salud Programa de Educacion, Salud y Alimentacion Procuraduria Federal para la Proteccion del Ambiente Programa Nacional de Financiamiento del Desarrollo Public Sector Borrowing Requirements Research and Development Secretaria de Agricultura, Ganaderia, Desarrollo Rural, Pesca y Alimentacion Structural Adjustment Loan Secretaria de Comunicaciones y Transportes Secretaria de Desarrollo Social Secretaria de Medio Ambiente y Recursos Naturales Secretaria de Energfa Secretaria de Educacion Publica Secretaria de la Funcion Publica Secretaria de Hacienda y Credito Publico Small and Medium Enterprises Subnational Govemment Sociedades Financieras de Objeto Limitado Secretaria de la Reforma Agraria Secretaria de Salud Southem Status Development Strategy Sector Wide Approach Technical Assistance Technical Assistance Loan Total Factors Productivity United Nations Universidad Nacional Autonoma de MCxico U S Agency for Intemacional Development Value Added Tax World Bank Group World Bank Institute Work Program Agreement World Trade Organization

IBRD IFC Vice President David de Ferranti VP, Investment Operations: Assaad Jabre Chief Economist: Guillermo Perry Director, LAC: Bernard Pasquier Country Director: Isabel Guerrero Manager: Toshiya Masuoka Task Managers: Miguel L6pez / Connie Luff Task Manager: Eduardo Wallentin

Team Production Support: Gabriela Vidals

MEXICO COUNTRY PARTNERSHIP STRATEGY

TABLE OF CONTENTS

EXECUTIVE SUMMARY .......................................................................................................... 1

I . INTRODUCTION ................................................................................................................. 4 I1 . COUNTRY CONTEXT .................................................................................................... 4

POLITICAL. SOCIAL AND ECONOMIC DEVELOPMENTS ................................................................. 4 POVERTY: PROFILE AND TRENDS ................................................................................................. 7

DEVELOPMENT CHALLENGES ................................................................................ 8 REDUCE POVERTY AND INEQUALITY ........................................................................................... 9 INCREASE COMPETITIVENESS ..................................................................................................... 13 STRENGTHEN INSTITUTIONS ....................................................................................................... 17 PROMOTE ENVIRONMENTAL SUSTAINABILITY ........................................................................... 20

THE WORLD BANK GROUP’S PARTNERSHIP STRATEGY ............................. 23 INPUTS To DESIGN THE STRATEGY ............................................................................................ 23

Country Partnership Strategy Evaluation and AAA Review ................................................. 23 Program Implementation ...................................................................................................... 25

Development Partners’ Activities ......................................................................................... 29 Mexico’s Debt Management Strategy ................................................................................... 30

Transition to a New Relationship ......................................................................................... 32

Lending Scenarios and IBRD’s Exposure ............................................................................. 36

Instruments to Increase Competitiveness .............................................................................. 38 Instruments to Strengthen Institutions .................................................................................. 41 Instruments to Promote Environmental Sustainability ......................................................... 43 IBRD ’s Financial Instruments .............................................................................................. 44

BUDGET TO IMPLEMENT THIS CPS ............................................................................................. 46

CPS MONITORING ..................................................................................................................... 47

CONCLUDING REMARKS ............................................................................................. 48

I11 .

I V .

Messages Received from Civil Society and the Global Pol l ................................................. 27

PROPOSED STRATEGY AND INSTRUMENTS ................................................................................. 3 2

World Bank Group’s Comparative Advantage and Focus ................................................... 33

Instruments to Reduce Poverty and Inequality ..................................................................... 37

R I S K S OF THE PROPOSED STRATEGY ......................................................................................... 47

V . TEXT BOXES

Box 1 . Highl ights o f Government Programs to Reduce Pover ty and Inequal i ty .................. 12 Box 2 . Highl ights o f Government Programs to Increase Competit iveness ....................... -16 Box 3 . H igh l igh ts o f Government Programs to Strengthen Inst i tut ions ........................... 19 Box 4 . Highlights o f Government Programs to Promote Environ . Sustainabil ity ................. 22 Box 5 . Main Messages Received from Civil Society ................................................. 27 Box 6 . Global Poll Results ................................................................................ 2 8

TABLES Table 1 . Mexico’s Ma in Macroeconomic Indicators .................................................. 5 Table 2 . Mexico and the Millennium Development Goals ........................................... 8 Table 3 . Partnerships in Mexico’s Development ..................................................... 30 Table 4 . Mexico’s WPA Orig . Allocations for FY03-04 and Projections for FY05-08 ....... 46

FIGURES Figure 1 . Figure 2 . Figure 3 .

ANNEXES A1 .

B1 . B 2 . B3 . B3 . B3 . B 4 . B5 . B 6 . B 7 . B 8 . B 8 . c1 . c 2 .

Credit to the Non-banking Private Sector ................................................. 14

Emerging Markets, Mexico and WB Spreads over U S Treasury 1993 -2003 ....... 45 Total Net Debt o f the Public Sector ...................................................... 31

Mexico . Country Development Objectives and WBG Partnership Strategy Monitoring Matr ix ........................................................................... 49 Mexico at a Glance ......................................................................... 53 Selected Indicators* o f Bank Portfolio Performance and Management ............. 55 IBRD Program Summary - Proposed IBRD Lending Program ..................... 56 IFC Program FY2001.2004 ................................................................... 57 Proposed IBRD/GEF/PCF Program Summary ............................................... 58 Summary o f Non-lending Services FY05.08 ........................................... 59

K e y Economic Indicators .................................................................. 61 Key Exposure Indicators .................................................................. -64

Mexico Social Indicators ....................................................................................... 60

Status o f Bank Group Operations in Mexico Operations Portfolio .................. 65 Statement o f IFC’s Held and Disbursed Portfolio ...................................... 66 IFC’s Commitments During the Previous CAS Period ......................................... 67 Program o f WBI Activities FY05.07 ..................................................... 68

ACKNOWLEDGEMENTS The World Bank Group greatly appreciates the collaboration and contributions o f the Mexican government in the preparation o f this CPS . The contributions o f those who were consulted during this process are also greatly appreciated. including representatives o f academic institutions. business chambers. indigenous groups. unions. non-government organizations. the private sector. and other development partners . Ma in contributors to the preparation o f this CPS were Mark Hagerstrom. John Kellenberg. Steven Webb. Joaquin Cottani. David Gould. Anna Wellenstein. Tova Solo. Krishna Challa. Conchita Espino. Philip Karp. and Daniel Morrow who. together with the C D and TMs. comprised the core team . Additional contributions were received from Keta Ruiz. Joost Draaisma. Gladys Lopez and Erica Soler. as wel l as all o f the Mexico extended team during brainstorming sessions held in July in Mexico City and September and October in Washington D C .

MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY PARTNERSHIP STRATEGY

OF THE WORLD BANK GROUP WITH THE UNITED MEXICAN STATES

EXECUTIVE SUMMARY

1. Mexico has undertaken impressive reforms since the 1994 crisis, leading to a major economic and political transformation in the last decade. Today, the country enjoys a more open economic and political system, i s more integrated into the world economy, belongs to the OECD, has investment grade in the financial markets and has strong ownership o f i t s development strategy. Yet, and not detracting from these achievements but rather pointing to the long-term nature o f development, there i s s t i l l a substantial agenda that the government seeks to advance within the context o f i t s National Development Plan, including very importantly poverty reduction, improved competitiveness, environmental management and institutional change.

11. So how does the Bank support a country with Mexico’s characteristics? This i s not an easy question given the Bank’s relatively small weight in covering the country’s financial needs, the non-additionality o f Bank loans for the sector ministries, and the need to customize Bank assistance to a creditworthy middle-income borrower. In some ways, such a strategy should not be different than that for other clients where the Bank also supports poverty alleviation, country ownership and a long-term vision. But for a country l ike Mexico, the Bank needs to customize i t s support by adapting to a sophisticated borrower and making sure the Bank i s particularly competitive in the instruments we offer, given the many options available for a country with investment grade and a significant IBRD lending program.

iii. In this CPS, it i s proposed in partnership with the government o f Mexico to address this challenge in three ways: (a) focus work on selected areas where the Bank can bring value added expertise and quality support to Mexico while being more selective in initiating the preparation o f lending operations; (b) use programmatic analytic work and learninghowledge sharing activities to help answer, debate and reach consensus around the main unanswered questions in selected areas (such as poverty, water, competitiveness, quality o f education and decentralization); and (c) be flexible to respond to windows o f opportunities which may arise during the CPS period (e.g. subnational lending) and ready to provide financial resources taking advantage o f WBG’s financial products that best suit Mexico’s needs.

iv. Mexico i s in the midst o f both a political and an economic transition, both o f which are intrinsically inter-connected and proving more challenging than originally anticipated. The political system i s in a process o f renewal and democratization-the election o f President Fox in July 2000 marked an important shift towards democracy and a multi-party system. The highly desirable political development involves managing a transition away from a

..

hierarchical-corporatist system that worked for seven decades and made policy making relatively straight forward. Today policy making i s much more complex, with the r ise of pluralism at the federal level, the decline o f Presidentialism, and the rising importance o f local governments ~ for social and economic ~ development.

v. The economic transition i s also proving more difficult than would have been expected a decade ago, when after the Brady-plan reduction o f debt and NAFTA it looked as if victory could be declared. Debt management has been extremely successful and the Brady bonds were paid 16 years ahead o f time in 2003. But the need to keep the budget in control and the l ow tax effort has meant that infrastructure needs are extremely high and growing. The legacy o f the 1994/95 crisis remains with Mexico, with poverty levels only now recovering to early 1990 levels. And after 10 years, the initial economic advantages o f NAFTA are being offset by increasing global competition, with China displacing Mexico as the second trading partner o f the U S in late 2003.

vi. How are these transitions linked to poverty reduction? Although Mexico has made important gains in health and education, l ow and inequitable growth has kept income poverty high. Improved economic growth i s constrained by low levels o f human capital, inadequate infrastructure and weak institutions (inadequate competition, property rights, private sector f i r m s s t i l l emerging from a history o f rent-seeking). Mexico also faces significant environmental degradation and water scarcity which could threaten growth, social welfare and poverty alleviation. Solutions to these problems are interconnected and require deep institutional change within government and state-society interactions. The competitiveness agenda i s crucial to poverty dynamics via job creation. And the institutional agenda is fundamental for competitiveness (the judicial system for example), for environmental management and to improve basic services to the poor.

vii. Taking into account this r ich and complex set o f challenges, the WBG will work in multisector clusters to adapt to these inter-related issues building on i t s strong partnership with government counterparts and working to adopt country processes in procurement, financial management and safeguards. We will use the best o f our new lending instruments, including SWAPS, repeater projects and financial products. These will be complemented by analytical work and by WBI learning and capacity building programs, which will be closely integrated with the country program. IFC’s program would continue to support efforts to: (a) enhance competitiveness o f the private sector; (b) hr ther deepen the financial sector; (c) promote investments in areas newly opened for private sector participation; (d) encourage sustainable social and environmental development; and (e) promote good corporate governance. IFC will implement this strategy through: (a) direct financing for larger clients to whom IFC can provide otherwise unavailable long-term financing and best practice expertise; (b) financing through intermediaries to reach small enterprises; and (c) targeted financing to small projects expected to have a high impact and a good probability o f success.

viii. The SHCP and the Bank have agreed to work in partnership during this CPS period (FY05-08) to implement a lending program that best addresses Mexico’s development needs as a creditworthy middle-income country and enhances the Bank’s ability to respond quickly to changing circumstances. A lending range o f US$O.8 to US$1.7 bi l l ion a year i s proposed in order to promote the country’s key development objectives supported through this CPS. The proposed lending range i s consistent wi th careful risk management, in view o f the government’s sound macroeconomic policies, its prudent debt management strategy, and the

2

projected evolution o f Bank exposure. In the event o f any significant changes in the proposed program, we would return to the Board with a CPS Progress Report.

ix. The proposed strategy faces r isks such as Congressional paralysis to implement reforms and the potential occurrence o f external shocks (such as a downturn in o i l prices, a stalled U S recovery, or contagion from shocks in other markets). There i s also the r i sk that more selectivity in Bank operations makes the lending program more sensitive to some operations being dropped. However, the focus o f the CPS heeds the lessons learned during the last decade and the implementation o f the proposed program has been designed with the management o f these r isks in mind.

x. Board members may wish to discuss the following aspects o f the CPS:

0 The proposed strategy to use programmatic assistance, organize thematic support groups and incorporate flexibility in the lending program; and

0 The proposal to move to country systems in procurement, financial management and safeguards during the CPS period.

3

I. INTRODUCTION

1. The last Country Assistance Strategy (CAS) for Mexico was presented to the Board in April 2602. I t was organized in l ine with the development challenges addressed in the country’s 2001 -2006 National Development Plan presented by the then new administration o f President Fox. In addition to a comprehensive program o f lending and non-lending services, the program included operations to support government reforms in pensions, finance, decentralization and infrastructure that have not yet been implemented due to lack o f legislative support-no single political party has a majority in Congress.

2. Consistent with Mexico’s status as a major middle-income country and OECD member, as well as to realign the Bank’s support to the government’s priorities for the remainder o f President Fox’s term, the government and the Bank have agreed to implement in partnership a new CPS to cover fiscal years 2005 through 2008, going into the beginning o f the next presidential term. This CPS proposes a selective program o f IBRD and IFC operations and a strategic program o f analytical and learning services to be provided by the WBG, al l built upon four strategic pillars to support Mexico’s efforts to: (a) reduce poverty and inequality; (b) increase competitiveness; (c) strengthen institutions; and (d) promote environmental sustainability.

11. COUNTRY CONTEXT

POLITICAL, SOCIAL AND ECONOMIC DEVELOPMENTS 3. Mexico i s in the midst o f two major transitions: a political-institutional one, and an economic one. The political system is going through a process o f renewal and democratization. The election o f President Fox in July 2000 marked an important shift towards increased political pluralism and a more effective separation o f powers, providing more checks and balances to the power vested in the President. Public decision-making i s broadly shared among different political parties. Mexico’s recent democratic transition has been a peacefbl and smooth process receiving widespread recognition at home and abroad.

4. On the other hand, the rise o f pluralism at the federal level and the increasing interest in the social and economic development agendas at subnational levels have hampered the administration’s ambitious reform agenda. Because no party holds a majority in either house o f Congress, the executive has had very limited success securing legislative approval on i t s reform proposals. The mid-term elections o f July 2003 confirmed the division o f electoral preferences as no single political party obtained a majority. All three major political parties now stand a reasonable chance to win the next presidential election. While there s t i l l may be a window o f opportunity to build consensus to pass some reforms, recent efforts on much needed fiscal reforms in December 2003 were not successful.

5. The government’s agenda, outlined in i t s medium-term National Program to Finance Development (PRONAFIDE) 2002-2006, includes major structural reforms in areas such as: fiscal management to reassign responsibilities among the federal and state governments, increase tax collection and reduce reliance on o i l revenue; energy sector reform to allow for private sector participation in meeting future demand; labor market regulation to reduce rigidities that hinder employment and productivity; public sector workers’ pension reform to

4

assure financial sustainability; development bank modernization to improve effectiveness, enhance corporate governance and increase operational efficiency; telecommunications regulation to foster a competitive environment, increase coverage, improve quality and reduce costs; and judicial modernization to strengthen the lower courts and make their operations more transparent.

6. The full implementation o f the government’s reform agenda i s expected to increase potential output growth by about two percentage points due to higher public and private investment as well as improvements in productivity growth. Given the current state o f the economy, potential output growth i s estimated to be slightly below 4 percent, which, without major reforms, i s unlikely to be sufficient to make noticeable progress in the reduction o f widespread poverty. Moreover, the protracted stagnation o f economic activity over the past three years has raised concerns about Mexico’s competitiveness and further highlighted the need o f implementing a comprehensive reform agenda.

7. Average annual real GDP growth in Mexico over the 2001-2003 period has been a lackluster 0.6 percent. The slowdown o f the U.S. economy in 2001 and i t s hesitant recovery reduced demand for Mexican non-oil exports. In addition, the reduction o f market share o f Mexican non-oil exports to the United States from 11.4 percent in 2001 to 10.7 percent in 2003 suggests that Mexico may be losing out to competitive pressures from abroad. Exports o f manufactured goods, which had quadrupled over the previous decade, have stagnated at about US$ 141 bi l l ion annually over the past three years and are about 3 percent lower than their historic high in 2000. Finally, a sharp contraction o f private investment, attributable to global economic uncertainties and lack o f domestic structural reforms, generated a deceleration o f domestic demand and contributed to the weak output growth performance.

8. Notwithstanding disappointing growth, Mexico has been able to maintain financial and price stability and access to capital markets during the global economic downturn and emerging market turbulence o f the past few years. Unlike many past episodes o f economic weakness, the recession was the f irst in Mexico’s recent history not associated with a balance o f payments or financial crisis. While there are sti l l concerns about the loss o f competitiveness, Mexico should be able to benefit from a sustained recovery in the U.S. and attain higher rates o f economic growth over the CPS implementation period (see Table 1) even in the face o f limited progress on the country’s structural reform agenda. Industrial production and trade figures for the last quarter o f 2003 already show a strong response to the upturn in U.S. economic activity.

Source: Bank staffprojections based on Banco de Mixico, INEGI and SHCP

9. Economic policy remains focused on price stability as a precondition to economic growth while, at the same time, pursuing structural reform to boost private investment and increase the country’s medium-term competitiveness and growth. Monetary policy i s aimed

5

at achieving a medium-term inflation target o f 3 percent with a margin o f plus/minus 1 percent. The gradual decline in inflation over the past few years and a 2003 year-end inflation within the medium-term target range has contributed to the credibility o f the monetary policy framework and the authorities’ commitment to the medium-term goals. This, in turn, has allowed the easing o f monetary policy, leading to substantially lower domestic market interest rates, and the development o f the longer-term fixed-rate debt market (the government recently issued a 20-year fixed rate peso denominated bond). Historically l ow interest rates are also improving the availability o f credit to the private sector.

10. The government has maintained tight fiscal policies, largely meeting its annually established fiscal targets and setting objectives for further, medium-term fiscal consolidation. Fiscal deficit targets have gradually been reduced, moving toward a balanced budget by the end o f the government’s term. Automatic budget adjustment rules requiring expenditure cuts in case o f lower-than-expected revenue and allocating higher-than-budgeted revenue have been adopted and applied through the annual budget laws. A broader Public Sector Borrowing Requirements (PSBR) deficit measure has also been adopted and i s published on a quarterly basis, strengthening the case for further medium-term fiscal consolidation. Mounting public expenditure pressures in areas o f social sector spending, public infrastructure, public sector pension reform, and declining o i l revenue will require a renewed effort at tax reform.

11. Mexico’s external accounts do not pose a risk to macroeconomic stability. The country’s external deficit (i.e. the balance o f payments’ current account) has been reduced over the past two years to about 2 percent o f GDP as a result o f strong o i l export revenue, rapidly increasing workers’ remittances, lower interest payments on external debt and subdued net import demand. Strengthening o f the external accounts and sound macroeconomic management allowed the country to broaden access to international capital markets and meet its external financing requirements.

12. Mexico adopted a floating exchange rate regime following the balance o f payments crisis o f 1994-95, with interventions in the exchange market normally limited to rule-based mechanisms. The flexible exchange rate provides a useful buffer against external shocks, such as a sudden fall in o i l prices, a significant drop in capital inflows or increased international competition. Over the past two years the peso has depreciated substantially with respect to the U S dollar due to several factors including relatively slow growth and limited progress on economic reforms. While depreciation may init ially compensate for part o f the deterioration o f external competitiveness, in the longer te rm the depreciation will not be able to substitute for economic reforms or public investment in infrastructure and education, which are needed to enhance competitiveness and reduce poverty.

13. The internal economic transition i s proving much more challenging than would have been expected a decade ago. After the resolution o f the debt crisis (with the issuance o f the Brady Bonds) and the implementation o f NAFTA, Mexico was believed to be in route for a long and sustained period o f economic development. However, the mid-ninety’s crisis and the recent slowdown o f economic activity highlight the fact that there are s t i l l unresolved structural development challenges. The legacy o f the 1994-95 crisis remains with Mexico as poverty levels only jus t recovered to early 1990’s levels and the advantages brought by NAFTA could be undermined if Mexico does not tackle the competitiveness agenda.

6

POVERTY: PROFILE AND TRENDS 14. Poverty in Mexico remains widespread. The 2000 official poverty numbers indicate that about 53 percent o f i t s population was suffering from income-poverty (defined as having a l e v 4 of per capita consumption below what i s needed to meet basic food and non-food needs), and close to 24 percent was extremely poor (below what i s required to meet basic food needs for adequate nutrition).' In 2000, 12.6 percent o f the urban population and 42.4 percent o f the rural population was extremely poor.* Preliminary government estimates for 2002 indicate a small decline in the broad conception o f poverty to about 52 percent and a significant fall in extreme poverty to 20 percent. 11 percent o f the urban population and 35 percent o f the rural population was extremely poor. In terms o f aggregate numbers, most o f the poor l ive in urban areas, yet poverty in rural areas i s more severe.

15. There has been a slow long-run progress in the reduction o f income poverty, overlaid with a dramatic impact o f the 1994-95 economic crisis. However, achievements have been imbalanced with important gains in health and education and lack o f progress in income poverty. Subsequent to the crisis, there i s a divergent relationship between poverty dynamics and national income growth in different periods. From 1996-2000, the economy grew at 5.5 percent per annum, but poverty fell slowly. In 2000, although mean income per capita had increased 11 percent in real terms compared to 1994, poverty had not recovered to pre-crisis levels, and unskilled wages had decreased by 22 percent in real terms. The share o f the population in extreme poverty in 2000 was s t i l l above the pre-crisis level o f 1994 by four percentage points in rural areas, and by three percentage points in urban areas. By contrast, in the 2000-2002 period, despite a fall in per capita income o f over 2 percent, poverty declined, with the 4 percent decline in extreme poverty o f particular note. Preliminary analysis by the government finds that this was due to an equalizing pattern o f income growth-heavily influenced by transfers, remittances, and growth in low skilled wages-in this period, with significant growth for the bottom deciles and a substantial decline for the top decile.

16. Despite this decline in poverty, achieving the MDGs will remain a challenge in Mexico. Assuming no change in income distribution and with an average yearly growth rate o f 3.5 percent GDP per capita, Mexico is unlikely to meet the goal o f reducing extreme poverty by hal f by the year 2015 (see Table 2). To do so, it i s estimated that Mexico needs a sustained growth rate o f at least 5 percent, which has not happened since the 1970's. Mexico i s also unlikely to reduce under-five mortality by two-thirds and maternal mortality by three quarters. However, it is likely to achieve universal primary education, the elimination o f gender disparity in al l levels o f education, and the reversal o f the spread o f HIV/AIDS. Moreover, in the recent past, income growth o f the extreme poor, especially in rural areas, has been lower than the average so specific efforts will be needed to reach the most disadvantaged groups o f the society in order to enable them to catch up with the rest o f the population.

' SEDESOL works with three poverty lines: food-based poverty, based on estimated food requirements to provide adequate nutrition assuming consumption pattems of the poor; plus two higher l ines that respectively add requirements for education and health, and for clothes, housing and transport. The first (extreme poverty) and third (poverty) l ines are quoted here. CortCs, Fernando, Daniel Hernandez, Enrique Hemhdez, Miguel Szekely, and Hadid Vera, 2002.

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Table 2. Mexico and the Millennium Development Goals Goal

Goals Current Position of Mexico* Projected position b y 2015 Achievemen 1. Reduce the proportion ofl In 1992, the official Mexican food based I Assuming an average annual economic I

2. Enroll all children, boys and girls, in primary school by 2015. 3. Eliminate gender disparity in basic education, preferably by 2005, and to a l l levels of education no later than 2015. 4. Reduce by two thirds the under-five mortality rate between 1990 and 2015.

peopre living h extreme poverty and those who suffer from hunger by half between 1990 and 2015.

In 1995, 94.1% of children 6-12 were enrolled in primary school; in 2002, 95.4%. coverage. In 1990, there was a 5% gender gap in basic school and 25% in higher education; in 2000 i t was 2 4 % for a l l levels of schooling.

Net primary school enrollment i s projected to increase to 96.8 %, practically full

There are no strong concerns regarding gender disparity in (basic) education in Mexico, more important for Mexico i s the gap for indigenous groups.

Likely

Likely

In 1990,44.7 per 1,000 under-five mortality rate, and 27.4 per 1,000 infant mortality rate; in 2000 i t was 25.2 and 17.9 respectively.

Under-five and infant mortality are projected to continue their reduction to 18.5 and 12.5 per 1,000 respectively, a reduction by an important 55-60 % though slightly

Unlikely

poverty was 22.5% and in 2002, i t was 20.0%.

practically stagnated over the past decade which makes i t unlikely for the rate to be reduced by three quarters by 2015.

Already a major reduction in the death rate due to malaria and tuberculosis has been attained over the past decade. HIV AIDS prevalence i s yet at a very low level.

growth rate of 3.5 %, the proportion o f people below the official food based poverty line would be reduced to 13.0%. An increase of the annual average economi growth rate to at least 5.0% would be needed to attain reduction of extreme poverty by half.

Unlikely

the maternal mortality ratio between 1990 and 2015.

6. Have halted and begun to reverse the spread of HIV/AIDS and the incidence o f malaria and other major diseases by 2015.

57 per 100,000 live births for 1990 and 2002 respectively. Correcting for underreporting the number of matemal mortality would increase to 85 and 79 for 1990 and 2002 respectively. In 1990,51.9per 100,000 was the malaria morbidity rate; in 2001, i t was 4.9. Deaths due to tuberculosis were 4.1 per 100,000 in 1990, and 2 in 2000. The HIV prevalence for female ages 15-24 i s 0.05-0.08% and in males i t i s 0.17-0.26%

Unlikely

Likely

I I (1999). * Source: Word Bank staff Calculations based on: Fuentes, R.. and Montes, A. “Country Case Study Towards the Millennium Developme Goals at the Sub-National Level: Mexico”, Ministry of Social Dev 2003

111. DEVELOPMENT CHALLENGES

17. Mexico’s 2001-2006 National Development Plan defines a “Vision o f Mexico in 2025” stating that i t “will be a fully democratic nation wi th a high quality o f l i fe that will have reduced its extreme social imbalances and will offer its citizens opportunities for integral human development and a living coexistence based on the full respect o f the ru le o f law and o f human rights. I t will be a dynamic nation, with leadership in the world, with a stable and competitive growth and with an all-inclusive development process in harmony with the environment. I t will be a nation proudly sustained in i t s roots, multi-ethnic and multicultural, w i th a profound sentiment o f national unityyy3. The government has stressed the importance o f fighting poverty and inequality. In President Fox’s Presidential Address to the Nation delivered on September 1, 2003, he stated that social development and the fight against poverty and inequality are the highest priority to his administration and summarized the government’s programs oriented to promote effective social policies.

National Development Plan 2001-2006, page 37; and also pages 73,97, and 127 for further details in the areas 3

of human and social development, growth with quality and order and respect.

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18. The National Development Plan defines the following basic objectives:

e e e e e e

e

e e

e

e e

Strengthen social capital and social cohesion Improve levels o f education and well being Increase equity and equality o f opportunities Manage the economy in a responsible manner Increase and expand country competitiveness Promote balanced regional development that includes al l segments o f the population Promote education for the development o f personal capacities as well as o f individual and collective initiatives Establish a new framework o f democratic governance Increase citizen confidence in its institutions, reduce the level o f corruption, and give absolute transparency to public sector management and performance. Promote a new federalism with the transfer o f functions and responsibilities to State and municipal governments Guarantee an expeditious and efficient judicial system Promote development in harmony with nature and the environment

19. Furthermore, the 2002-2006 PRONAFIDE outlines the actions needed to finance the National Development Plan objectives. This CPS proposes to support the government’s efforts to finance i t s development objectives detailed above addressing them in four pillars- reduce poverty and inequality, increase competitiveness, strengthen institutions and promote environmental sustainability (see Annex 1 for more details)-under which this section o f the document groups the analysis o f the main development challenges that Mexico faces today. These four pillars are strongly interconnected. The competitiveness agenda i s crucial to poverty dynamics via j ob creation. The institutional agenda i s fundamental to improve basic services-especially for the poor, make institutions more competitive, and strengthen environmental management.

REDUCE POVERTY AND INEQUALITY

20. As already introduced in the profile and trends section, poverty in Mexico remains widespread and suffers from four persistent characteristics: (a) although reduced, absolute poverty (below SEDESOL’s asset poverty line) numbers remain unacceptably high (some 5 1 mi l l ion Mexicans are s t i l l poor); (b) there i s sharp inequality in the distribution o f income, which has been resilient to policy interventions; (c) the incidence o f extreme poverty in rural areas i s abnormally acute (in 2000, 42 percent o f the rural population lived in extreme poverty); and (d) there s t i l l i s wide development gap between the South and the rest o f Mexico (southerners are far poorer, less educated, less l ikely to have running water, and more l ikely to die younger). At the same time, urban poverty remains a challenge, which requires new approaches beyond the rural focus o f most previous interventions. These characteristics gather additional urgency when seen in the light o f the available employment opportunities for the poor-while unemployment has remained low, some 1.5 mi l l ion new jobs are needed each year just to accommodate new entrants into the labor force. At the peak o f i t s recent growth performance, the Mexican economy managed to create only about 600,000 formal jobs. Thus, dealing with the increasing informal sector must be at the center o f any poverty reduction initiative.

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21. The remaining challenges in reducing poverty and inequality, point to an enhanced development agenda-one that combines the effect o f a solid macroeconomic framework and sustained growth with policy interventions by sector and region in order to bring the benefits o f growth to al l Mexicans. This encompasses reform challenges affecting income growth, social protection, education, health, specific needs o f indigenous peoples, women, and the rural and urban poor, basic infrastructure, and housing.

22. Income Dynamics. Reducing income poverty depends primarily on the expansion o f labor incomes-in formal sector jobs, in the informal sector, and in the rural agricultural and non-farm sector. This i s powerfully influenced by economic growth, and i s intimately linked with policies for competitiveness (see next section). Policy can also influence the pattem o f growth, in ways that encourage income growth in poorer segments o f the society, and so lower income inequalities. Action in a number o f intersecting areas is needed. Formal job creation will require measures that improve the investment environment o f medium and large firms, including policies that reduce disincentives for formal job creation whilst protecting basic labor rights. There i s a complementary agenda o f improving the investment environment for micro and small enterprises, including micro entrepreneurs, through measures that improve property rights, provide quality infrastructure and financial services to small f i rms, regulatory reform to reduce costs o f doing business and technical assistance. The government has recently introduced i t s IMPULSO strategy to make a systematic effort to address the income growth agenda for the moderate urban poor. The major challenge in rural poor areas i s to shape rural development policy, including territorial strategies, around the needs and productive potential o f peasant farmers, including in particular indigenous groups, and provide the infrastructure and other economic services that will support the rural non- farm sectors. Migration to cities and abroad will continue to be a major route out o f poverty for some areas; continued efforts to develop a more efficient formal system to reduce the cost o f remittances and make them more transparent, as wel l as measures to facilitate rural financial services, would harness the development potential in worker remittances. Finally, special attention needs to be given to the overall spatial distribution o f development, for example through reducing costs o f intemal transportation within Mexico.

23. Social Protection. The social security system covers only 1 in every 5 o f the urban elderly population, and only 2 percent o f the total poor. In social insurance, the pension system has benefited the formal, middle-class workers, and le f t out the informal, the poor, and the unemployed. Mexico has begun to fill parts o f this gap through OPORTUNIDADES (formerly PROGRESA), a direct income transfer arrangement for the poor conditional on the use o f selected education, health, and nutritional services. Yet, important gaps in the social protection system remain, particularly among the rural poor without access to health and education services and the urban poor to which programs such as OPORTUNIDADES have only recently been extended.

24. Education. The poor have benefited from centralized outreach programs designed to provide service to marginal rural areas. Increased spending in education has allowed for near universal access to primary education and secondary enrollment i s high and continues to increase. Public spending in higher education, however, continues to be highly regressive and access by the poor remains a challenge. Moreover, while coverage has increased in basic education, the out-of-school adult population without secondary education remains a challenge, requiring greater emphasis on non-formal education in order to respond to the

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demands o f a modernizing economy. Such demands are also placing a premium on the quality in education, where the system in general lags. A systemic effort would require going beyond the centralized approach and involves decentralized governments, who are responsible for basic education services, and collaboration with communities and teachers.

25. Health. Mexico has used centralized institutions and vertical programs to control infectious diseases and increase prevention and education among the poor through the provision o f services in marginal rural areas. This has helped bring about important advances with lower infant mortality, higher vaccination rates, and higher l i fe expectancy. These and other factors have begun to change the country’s epidemiological profile, and now chronic diseases and injuries are becoming the main causes o f death and disability. In addition, the challenge now i s to continue efforts in creating an equitable healthcare delivery system with improved quality and the alleviation o f the financial burden o f catastrophic i l lness that exacerbate poverty. While the population engaged in the formal labor market benefits from health insurance more than hal f o f the labor force i s in the informal sector and remains largely uninsured (more than 80 percent in the South).

26. Excluded Groups. The challenge o f human capital formation i s particularly difficult for three, overlapping social groups-women, indigenous populations, and the rural poor. Longstanding demands-regional, rural, indigenous-have been heightened by the political opening, the poor growth performance and international integration. Socially ascribed gender roles have placed women at a clear disadvantage in terms o f health (especially reproductive health), labor, and personal safety. Similarly, about 1 in 10 Mexicans defines himself or herself as indigenous and may hold a different set o f economic values, whereby assets (especially land) are non-tradable sources o f group identity, community benefit is held in higher regard than individual profit maximization, traditional social governance bodies are trusted over those dictated by the country’s laws, social organization i s based on prestige and civic duty, and the language o f preference (and frequently the only language) i s not Spanish. These overlapping groups, themselves, are concentrated in the southern States, which under- perform the rest o f the nation, specifically in the areas o f education, health and the provision o f basic services. In 2000, access to piped water was 20 percent below the national average, enrollment o f school age population was 10 percent less, and deaths per 1,000 births averaged 5.4 more than nationally. In order to “catch up” with the nation, these States must address challenges related to low income per capita, smallhemote localities, and large proportions o f rural and indigenous populations, in addition to the inefficient use o f existing resources and the need for additional resources to move forward at a faster pace.

27. Large numbers o f people are without access to basic infrastructure services, undermining efforts at human capital development: 13.2 mi l l ion without piped water, 23.7 mi l l ion without sanitary drainage, and 5.4 mi l l ion without electricity. Transport, particularly in rural areas, i s lacking and hampers the poor’s ability to access markets and services-road coverage i s high in Mexico, but public transport (whether privately or publicly provided) i s sorely lacking. In addition, the quality o f service i s poor, particularly among low income populations; for example, only about ha l f the households living in poor urban neighborhood get water every day, 24 hours a day. This incomplete coverage and poor quality o f infrastructure services continues despite the substantial inf low o f public resources. Electricity subsidies, for example, account for nearly 3 percent o f public expenditure, but do little for the poor since they are badly targeted.

Basic Infrastructure.

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28. Housing. Mexico has a large housing deficit, currently estimated at 4 mi l l ion units, which i s worsening due to the rapidly growing demand (700,000 new households are formed each year) and limitations on funding availability. Currently, over 40 percent o f Mexicans l ive in informal housing characterized by temporary construction materials, lack o f services, insecurity o f tenure and, in many cases, situated in areas at risk for natural disasters (68 percent o f people affected by natural disasters are poor). Despite progress in financial sector reforms including recent substantial enhancement o f secured lending regulations, the housing market s t i l l faces problems o f dysfunctional land markets, which also hinder efficient agricultural production in rural areas. Finally, only 20 percent o f urban Mexicans and even fewer rural ones have access to financial services, limiting their ability to save, invest and manage risks. At year-end 2002, the total mortgage debt represented 3.1 percent o f GDP, compared to 12, 15, and 68 percent for Colombia, Chile and the U.S., respectively. In urban areas effective programs have yet to be tested and will require a greater role by municipalities and overall reforms in factors markets. The market i s very segmented with banks providing financing only to the higher income brackets and SOFOLES focusing mostly o n the low to middle income housing segment. Past experience in rural areas suggests that this will not be an easy task. Increased spending alone will not bring sustained changes without improvements in housing and land markets, in access to financial services, and in local government capacity and accountability.

I Box 1. Highlights of Government Programs to Reduce Poverty and Inequality

Through SEDESOL, the current administration i s seeking to coordinate and develop as needed, programs tc address social r isks through a life-cycle approach (CONTIGO) and an inter-ministerial body has been created foi this effort. Moreover, the effectiveness and impact o f social programs has become an increasing priori ty anc annual evaluations are now mandated by law. In concert, the Health Secretariat (SSA) through the new Genera Health Law i s expanding i t s p i lot program o f Seguro Popular, which seeks to provide health insurance for the uninsured poor. The Law provides the framework needed for reforms in health services, together with privatr (IMSS) and public (ISSSTE) providers and insurers, in pursuit of a more equitable system with quality and financial protection. In education, the Education Secretariat (SEP) i s continuing i t s efforts to increase access ta education by the rural poor through the CONAFE program, where important achievements have been seen on the quality side as well, and has inaugurated new programs targeting the rural poor.

Sustainable poverty reduction, however, needs to go beyond interventions to support human capital development to encompass “economic empowerment” o f the poor. The continuing high levels o f poverty and persistent inequity which has largely been immune to the effects o f growth wil l require more emphasis on interventions in the economic aspects o f poverty. The framework for this approach i s being developed unde1 CONTIGO. Whi le the job-creation strategy l i es mainly in the environment for private investment, CONTIGO i s pursuing an asset-based strategy focusing o n land regularization and patterns o f infrastructure provision, complemented by actions to reduce regulatory burdens o n small enterprises. Helping the poor to build physical and financial assets would provide a means to better cope with economic shocks and improve their lo t over time. In addition to i ts OPORTLJNIDADES program that focuses on the extreme poor, the government has recently introduced i t s IMPULSO strategy to address the income growth agenda for the moderate urban poor. Also, to facilitate access to financial services by micro- and small-enterprises, as we l l as the self employed, the government also established BANSEFI.

The current administration established a new mortgage financing institution Sociedad Hipotecaria Federal, enhanced secured lending regulations, has made housing a priori ty and expects to bring construction o f new u n i t s up from i t s current level o f 400,000 per year to 750,000 new uni ts by the end o f the presidential term. The sector i s undergoing structural changes as the government i s shifting i t s role from financing construction to providing guarantees to SOFOLES so that these can raise themselves financing in the markets and effectively tap the capital markets for both construction and long-term mortgage financing.

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INCREASE COMPETITIVENESS 29. Mexico enjoyed the benefits o f the global economy, particularly NAFTA, through the last ha l f o f the 1990s. From 2000 to 2002, however, Mexico’s exports have slipped and the ‘maquila sector’ has shrunk more than 15 percent losing jobs and f i r m s to other regions, in part due to the economic slowdown in the U.S. but more worrisome due to the increased competition from other countries. In 2003, China surpassed Mexico as the United States’ second largest trading partner after Canada. While China’s exports to the U.S. increased about 55 percent in the last three years, preliminary numbers indicate that Mexican exports to the U.S. in 2003 were below the 2000 level. This has come not only as a result o f China’s lower labor costs but also, among other reasons, fi-om policies that created an environment that has enabled massive private sector investment and growth. Such policies were directed at improving education quality and labor skills, providing more access to financing, improving infrastructure and reducing logistics costs, raising investment in R&D, and moving into higher value-added manufacturing activities, including high-tech.

30. Mexico’s survival and growth o f both i t s large export-oriented firms and its small- and medium-sized f i r m s poised to enter global markets will depend on their capacity to compete on a world level. Traditionally growth in Mexico has been driven by labor market growth and (to a lesser extent) capital accumulation. During the last decade, Total Factor Productivity (TFP) contribution has been minimal (0.12 percent from 1991 to 2000). Increasing private sector labor productivity, in the face o f rising external pressures, will require reduced costs o f financing accompanied by greater access to financial services, infrastructure, logistics services, efficiently regulated public-utility services, and skilled labor; less cumbersome government regulations and procedures; greater dynamism at sub-national levels; enhanced corporate governance in both public and private sectors; improved products and services; and better integrated supply chains (an area with considerable growth, income, and employment opportunities for the development o f small and medium size enterprises).

3 1. Trade. Trade facilitation wi th in the NAFTA had early positive results although the advantage o f preferential access to the U.S. market i s rapidly being eroded by international competition. This will be further worsened with the expiration o f preferential treatment in agriculture under NAFTA and the decrease in U.S. tariffs with respect to other countries that compete with Mexico. Also, Mexico has had limited success in providing incentives for European and Asian f i r m s to re-invest. Incentives for maquilas to establish strategic alliances outside o f NAFTA are weak, partly explained by labor rigidities (see below). Finally, illegal trade and corruption through triangularization o f imports from Asia to Mexico and uneven application o f quality norms reduce the benefits o f NAFTA.

32. Financial Sector. A broad-based and efficient financial system i s key to Mexico’s competitiveness. Government’s success in establishing macro-economic stability and sector reforms-including putting in place an adequately capitalized banking system with solid regulatory, supervisory and loan recovery frameworks-helped the country move beyond the 1995 crisis and set the stage for the recovery o f the domestic credit market. However, further recovery o f the demand wil l only happen if higher rates of economic growth are attained and additional reforms aimed at broadening access to finance are implemented. While top t ier companies with sound finances can raise domestic funding at very attractive rates, access to financing s t i l l remains very l imi ted-credi t to the private sector amounts to about 25 percent o f GDP, less than hal f o f the share in Chile and one seventh o f the one in China. Moreover,

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the demand for external capital by the non-banking private sector has continued to decrease (see Figure 1 below). And, although issuance o f domestic paper by the private sector has increased considerably during the last two years, selected top t ier companies account for more than two-thirds o f the market. For particular groups o f middlekmall companies and individuals access to financing i s even more limited (about 75 percent o f adults in metropolitan areas and about 85 percent o f individual entrepreneurs are unbanked), with consequences for the payment systems and limiting investment choices and r i s k management activities. Broader availability o f funds for continued investment i s crucial to Mexico’s competitiveness.

Figure 1. Credit to the Non-banking Private Sector

Domestic Credit to the Private Sector as % o f G D P

1996 1997 1998 1999 Zoo0 2001 2002 2003*

* Jan-Nov Banking 0 Non-Banking

External N e t Debt Flows to the Non-Banking Private Sector

7.5

6.0

4 5

2 3.0

1.5

0.0

a ’ Y)

15% 1997 1998 1999 Zoo0 2001 2001 2003* * Jan-Sep

33. Infrastructure and Logistics. Reliable and affordable public uti l i ty services and infrastructure within a framework o f fiscal restraint also form an important challenge for Mexico. The collapse o f investment in infrastructure from levels between 2 and 2.5 percent o f GDP in most o f the 1980’s and first ha l f o f the 1990’s to levels between 0.8 and 1.3 percent of GDP in the second hal f o f the 1990’s points to the major challenges remaining after privatization and public sector reform, as wel l as to the importance o f tax reform to regain higher investment levels. In the case o f the energy sector, improving the business climate calls for further unbundling o f activities, strengthening regulatory frameworks, increasing private investment, and enhancing corporate governance. Hydrocarbons i s the largest sector in the economy and Petrbleos Mexicanos (PEMEX) has a major challenge ahead to up production and improve its efficiency and accountability. Under a business-as-usual scenario, Mexico will need to import 25 percent o f its natural gas needs in the next decade. Although electricity services are today reasonably reliable, some 40 percent o f the Comisibn Federal de Electricidad (CFE)’s installed capacity i s over 35 years old and i s due for replacement, and concerns about the reliability o f electricity supply are impacting today’s foreign investment decisions in the industrial sectors. At the same time, the Kyoto Protocol could open the way for Mexico to develop a large market in carbon trading. Limited independent regulation has hampered efficiency gains f rom private participation in affected sectors-notably ra i l and telecom. The latter, in particular, has yet to show the hll benefits o f privatization. Lastly, Mexico’s logistic costs at about 18 percent o f GDP are high compared to other OECD countries. This erodes the location competitive advantage that Mexico has vis-h-vis the U.S. Increases in efficiency and reduction in costs o f the various components o f the logistics chain (ports, customs, transport services, border passage, multi-modal services, and safety-security costs add 5 to 7 percent to the value o f goods in Mexico, in comparison to a more common figure o f around 1 percent) are a priority.

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34. Labor. Integration into the global economy i s also creating demands in labor force training. Mexico has been successful in reaching near universal primary and secondary enrollment and attention i s now focused on education quality and non-formal education. At the tertiary education level, access and coverage lags noticeable in comparison to i t s OECD partners. The poor match between supply and demand for sk i l ls points to the need to improve the quality o f education, strengthen l i n k s between the education system and industry, and to increase coverage o f tertiary education, especially among the poor. Labor and labor- associated costs (social security, pensions, housing, etc.) in Mexico are rigid and high compared to other peer countries. Strict firing regulations and an emphasis on job stability in the labor laws limit hiring modalities and force companies to absorb wages as fixed costs, reducing the f i rm ’s ability to retool in reaction to a changing external environment. These issues, combined with weak labor-dispute settlement mechanisms form a big incentive to hire workers informally. From 2001 to 2002, the informal labor force increased from 24 to 25.6 mi l l ion workers while the formal labor force decreased from 15.3 to 15.1 million.

35. Judicial and Bureaucratic Procedures. Another challenge to competitiveness i s further streamlining and making more transparent judicial and bureaucratic procedures. I t takes over 50 business days to register a business in Mexico compared with 2 days in Canada. I t takes 325 days on average to resolve a business dispute in Mexico. Lack o f contractual security has prompted entrepreneurs to resort to private agreements to resolve contract breaches, or forego contracting with unknown clients altogether. Market exit and entry costs are high as are the administrative burden for expanding productive chains to small enterprises and the transaction costs surrounding tax payments. The rate at which States issue and change norms compounds the uncertainty, as does the lack o f coordination among government levels.

36. Quality and Innovation. While Mexico has benefited from knowledge sharing wi th parent companies in the U.S., this has not translated into robust levels o f domestic innovation and technology development. Technology transfer to Mexico has been very dynamic (behind only Singapore, Ireland and Luxemburg and significantly better than comparator countries such as Poland, Hungary and Malaysia). Domestic research and development has lagged, however, as evidenced by a record o f patents and published research which falls far from comparable countries such as Chile and Venezuela. Moreover, the low level o f transformation o f R&D into commercial applications points to inefficient use o f scarce resources and poor collaboration between researchers and the private sector, magnified by the difficulties associated with business start-ups, obtaining credit or venture capital.

37. Small and Medium Enterprises (SMEs). Further integration o f SMEs, including micro businesses and entrepreneurs, provides opportunities for improvements in growth, income distribution and competitiveness. SMEs may represent as much as three quarters o f total employment. Supply chain integration continues to be a challenge for SMEs, which lack the knowledge and production techniques to improve quality for certification and to establish l i n k s with larger f i r m s and export markets.

38. Agriculture. Agricultural growth, in spite o f trade and land reform and elimination o f price interventions, has been stagnant. The sector now faces the expiration o f preferential treatment under NAFTA. Advancing and integrating agro-industry requires improved product quality, certification and distribution processes, as wel l as access to larger tracks of land. Progress on these f ionts-combined with actions outlined above in terms o f access to finance,

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labor reform and reducing regulatory costs-will help the agricultural sector develop i t s internal markets and reach export markets.

Box 2. Highlights of Government Programs to Increase Competitiveness

The government’s competitiveness policy targets j o b recovery and retention, increasing export businesses and stimulating the private sector in high value-added sectors. Implici t in th is approach i s the recognition that Mexico’s perceived competitive advantages-such as cheaper labor relative to, and geographical proximity to the U.S-will eventually become irrelevant. Competitiveness must now come through reducing unnecessarily high production costs, increasing productivity through technological upgrading, and establishing diversified strategic sector associations. Reflecting the importance o f this endeavor, a Presidential Competitiveness Council has been formed and twelve sectors have been identified for which integrated sector strategies wil l be developed-five o f which have been completed. These strategies include a broad set o f reforms to reduce production costs through better product supplies and aligning their norms with those o f importing countries.

Since the mid-l990s, Mexico has embarked on substantial financial sector reforms aimed at bolstering capitalization and soundness o f banks through an overhaul o f the supervisory system, resolution o f troubled banks, and phasing out o f the universal deposit guarantee. More recently, the government implemented enhanced legislation to regulate savings and credit institutions, to strengthen secured lending, and took steps to improve credit information systems. Reforms were implemented to improve its development banks’ efficiency and reduce their associated fiscal costs-most notably through the liquidation of BANRURAL and the establishment o f Financiera Rural and Sociedad Hipotecaria Federal.

Labor reform has been a subject o f much attention by the government and the public in general. After a year o f negotiations, employers and employees have jo int ly placed a reform bill before Congress. This i s complemented by increased efforts in science, technology and innovation through the creation and implementation o f a coherent pol icy to increase collaboration with private firms. Accordingly, the CONACYT general director has been raised to a quasi-cabinet member, an independent l ine o f budget provided, and finding increased and refocused to stimulate private R&D investment. The government has also placed considerable emphasis on improving sk i l ls in the out o f school population through the creation o f the Consejo Nacional para la Vida y Trabajo (CONEVyT) as a ministerial level agency.

The government has promoted the streamlining of business opening procedures and i s preparing a fast track business entrCe system that would benefit 55 percent o f the economic activities registered in INEGI. Similar regulatory improvements are also considered at the State and municipal levels. Efforts in judicial system and procedures have focused o n criminal justice institutions and the judiciary in general. The presidents o f the National Commission o f State Courts (NCSC), in collaboration with the Federal Government, SHCP and BANOBRAS, have initiated a program to assist State judicial branches to improve their institutional structure, efficiency, efficacy and transparency.

The government i s attempting to implement reforms in infrastructure and service sectors, focusing on sector restructuring, competition and regulation to increase performance and investment. The government presented to Congress without success an electric sector reform aimed at facilitating greater private participation in generation and unbundling transmission and distribution. The government has begun granting concessions for natural gas development and extraction and efforts are also underway to launch a system o f road concessions and sustainable highway finance arrangements. In telecommunications, SCT i s focusing on strengthening the eegulatory framework within existing legislation, and working along with e-Mexico to close the digital divide.

The government has targeted actions to address SMEs. The government has targeted in particular those inked to export markets with increasing access to financing, capacity building, and information services, :omplemented by efforts on supply chain integration through funding for productive projects with regional mpact. In the f i rst ha l f o f 2002 alone, government funding help to set up 158 integrating businesses that j o i n wer 2,899 SMEs.

In terms o f the rural sector, SAGARPA has developed a coherent framework for agricultural levelopment policy and i s working to bring other secretaries into the framework for a more coordinated effort to :hange in rural areas. Improved integration in factor markets has received support in terms o f access to finance is outlined above, as we l l as through SRA completion o f the land regularization program in the social sector.

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STRENGTHEN INSTITUTIONS 39. Over the past 15 years, multiparty political competition at all 3 levels o f government has activated a democratic federal system, replacing the single party system that had been in place €or decades. Making the new system fully operational, however, requires further institutional reforms. The present administration, l ike the previous, seeks to leave an institutional legacy o f transparency, accountability, and federalism that will hinder prospects o f future political monopolies. The external opening o f the economy makes institutional strengthening more urgent, because good institutional software seems to be the most important contributor to sustained competitiveness and per-capita income growth. Also, the economic opening makes institutional reform less vulnerable to reversal, as the benefits o f international linkages increase the numbers o f people favoring the better institutions that make Mexico more competitive. While the theme o f institutional strengthening could touch on most o f Mexico’s development challenges, the discussion here focuses on what could realistically be undertaken and on what i s not covered elsewhere in the CPS.

40. Civil Society and Inclusion. Democracy in Mexico, traditionally operated through corporatist channels into a single party, now rightly takes place through multi-party competition. Today, people have the option to be heard through civ i l organizations independent o f parties, corporatist organizations (unions, chambers o f commerce, etc.) and the government. I t i s particularly important for vulnerable groups, l ike indigenous peoples, women and youth, to also have established institutional channels for expressing c iv i l society views. Mexico’s public administration will benefit by having more efficient flows o f information in both directions between decision-making levels and those in contact with stakeholders, by building internal cohesion around clear objectives and shared strategies for change, and by creating mechanisms for open exchanges o f ideas among officials at various levels and in different agencies concerned with the same issues.

41. Transparency and Anticorruption. The government has advanced many reforms to improve transparency and reduce corruption, especially in the customs and procurement areas. However, progress regarding government procurement i s uneven. In most agencies procurement practice s t i l l emphasizes following complex procedures rather than getting the best value for money for the public sector. One o f the actions to improve transparency was to open to c iv i l society the monitoring o f government procurement processes for very large contracts. Another important action was the creation o f the Federal Institute to Access Information (IFAI) and the enactment o f the new law that makes disclosure o f certain information mandatory. A major improvement in procurement processes was introduced with the electronic procurement portal (COMPRANET) that allows for electronic management o f bidding processes-the next generation o f COMPRANET will also include shopping- although the system i s not yet used at the State level. Likewise, financial management i s strong in some areas, but weak in others, again leaving too many opportunities for corruption. More and more government agencies have been making information public, but the quality and coverage are uneven and until recently people had little chance to dig deeper with any inquiry. Local services networks, one stop service centers, service quality, simplified procedures, computer-based systems, automated controls and proper audit trails need further development in order to provide higher quality o f services as well as accurate and timely information to Mexico’s citizens.

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42. Government Personnel-Civil Service and Pensions. A new Law was recently passed to implement c iv i l service in government. The c iv i l service should, while not promising life-tenure, certify professional capability and achievements and define reasonable career paths for public employees. I t should also provide job security for talented professionals that want to pursue fruitful public sector careers without the need, as in the past, to affiliate to a particular political party. Also, rapid growth o f public employment in the past resulted in the use o f a pay-as-you-go pension system for public workers, wi th generously defined benefits for some sectors. With retirements accelerating and public employment stalled, the system i s now going into deficit. More public employees are interested in employment opportunities in the private sector, but they do not want to lose accumulated pension benefits. A few years ago a reform o f the pension system for the private sector, giving employees individual portable accounts, took care o f most o f these problems for the formal private sector, and the government is considering a similar reform for public pensions. This strategy could also help address the problem o f subnational governments’ employee pension systems,

43. Fiscal Policy Institutions. Mexican fiscal policy has improved greatly in keeping sustainable fiscal balances, even in the face o f recession. There is, however, s t i l l room to improve the efficiency o f taxes (including contributions to social security, housing, etc.) to raise revenue, as wel l as o f spending to better allocate resources to nation-wide priorities. Congressional mandates and past concessions to special interests have put so many rigidities in the budget that adjustments to revenue shortfalls or changing priorities tend to affect the most flexible part o f public spending, investment; and VAT and income tax bases remain too narrow, with too many exemptions.

44. Intergovernmental Fiscal Relations. The 1990s witnessed major expansions in the transfers and spending responsibilities for the subnational governments, but federalism needs hrther reform to complete the transformations underway to achieve the outcomes desired. Although a lot o f money now flows through State coffers (mostly to pay teachers and health workers), not a l l levels o f government have ownership o f the decentralization process, as unclear roles, strong links between unions and their federal sector ministries, and lack o f political will by State governments lead to ineffective management o f key public services. States also lack substantive tax bases, and the development bank BANOBRAS has to strengthen its function in order to get the SNGs access to international financing at competitive rates.

45. Strengthening Capacity o f SNG. Along with the SNGs’ problems o f inadequate authority over their finances and spending, most o f them lack management capacity to do more (there are a few exceptions, among the economically stronger States and municipalities). Areas o f weaknesses include strategy design and investment planning for economic development, results-based and efficient expenditure management to improve services provided to the poorest population, procurement and financial management, tax administration, crime and violence prevention, and justice administration.

46. Justice System. Mexico’s judicial system i s not meeting i t s objectives to secure property rights, facilitate stability in commercial and financial interchanges (contracts, bankruptcy, etc.), foster a respect for cultural diversity, and provide security against crime and violence. Marginalized groups l ike women and the indigenous suffer particularly from judicial inefficiency. These shortcomings have both social and economic costs, in lost foreign

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and domestic investment that would have fostered economic growth. Despite some reforms, the thirty-two State judicial systems, which handle majority o f the country’s caseload, face several institutional obstacles: (a) an inefficient, inaccessible and inequitable administration o f justice; _(b) problems o f impunity, lack o f independence and corruption among judges, resulting in a negative public perception of the judicial system; (c) poor communication and coordination among criminal justice institutions; and (d) a general lack o f public knowledge about the judicial system and citizens’ rights.

Box 3. Highlights of Government Programs to Strengthen Institutions

Transparency and anticorruption. In line with the government’s strong commitment to greater transparency, the L a w o f Public Access to Information o f 2003 led to the creation o f a special office for thai purpose; it has already opened computer kiosks in many public agencies, so people can download the information they want. The COMPRANET e-procurement program continues to expand i t s coverage. As this develops into a comprehensive electronic project, it wil l accelerate the whole government’s efficiency and effectiveness.

Government personnel. The government has developed an innovative and financially sound proposal for reform o f ISSSTE (which would also help the overall fiscal situation and contribute to more system reforms underway in social protection and health). D e facto a professional c iv i l service has started to emerge with the retention o f many senior staff in the historic political transition to a new party o f government in 2000-01. The government i s implementing i t s new c iv i l service law, starting with the personnel accreditation process for mid- management positions in the Federal Government and with an intensive pi lot in SHCP.

Fiscal policy Institutions. Mexico has been implementing stronger fiscal management procedures, codified in the 2002-2006 PRONAFIDE. SHCP i s re-engineering i tself as a model for the rest o f the Federal government, which includes streamlining i t s internal process as we l l as reforming the budgeting and tax administration processes with which the ministry interacts w i th the rest o f government and the wider economy. The contemplated budgetary reforms include medium-term financial planning, performance budgeting, treasury reform, and more strategic public investment selection.

Intergovernmental relations. The government i s considering reforms to the Fiscal Pact and will ho ld the Convencibn Nacional Hacendaria in February-July 2004 to push the dialogue among a l l levels o f government further, possibly including wider fiscal reform. Spending management, particularly education, health, transport and environment are also critical for making the new federalism actually work. The new mechanisms for SNGs to borrow from the market seem to be working for the more creditworthy ones.

Strengthening capacity of SNGs. The government has on-going programs to strengthen SNG’s capacity, especially through FORTEM for municipalities, for whom federal contributions have greatly increased since 1998. Preventing crime and violence became a responsibility for municipalities in 2000, according to a new article o f the national Constitution. Mexico C i ty and one or two other large cities have hired private-sector firms to assist in developing crime-abatement strategies.

Justice System. The National Development Plan (2001-2006) assigns a high priori ty to the justice sector. The Federal Government has initiated e l Fondo Nacional de Seguridad Publica (FOSEG), a program of assistance to Federal and State Public Ministries and other criminal justice institutions. State governments and judiciaries recognize the need to improve the hnct ioning of judicial institutions and strengthen the rule o f law. The NCSC, in collaboration with the Federal Government, SHCP and BANOBRAS, has initiated a program to assist State judicial branches in improving their: (a) institutional structure, organizational culture and knowledge sharing; (b) efficiency and efficacy in service delivery; (c) transparency in case processing and public information; and (d) accessibility.

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PROMOTE ENVIRONMENTAL SUSTAINABILITY Mexico today faces tremendous pressure on its natural environment. 47. Available

information on Mexico’s environmental status suggests that severe degradation has taken place in a number o f sectors-to the point where failure to reverse some o f the most damaging environmental trends could not only act as a brake on continued growth but in some cases contribute directly to reduced social welfare and increased poverty. During the 1990s, environmental deterioration was estimated at around 10 percent o f GDP. Approximately 90 percent was due to environmental degradation (mostly pollution) from economic activities; 10 percent represented natural resource depletion. Given the magnitude o f Mexico’s environmental challenges and the relatively short time that has passed since i t began to formulate a comprehensive response, there remains a considerable unfinished agenda to improve the environment over the next decade.

48. Environmental Governance. Since the mid-l990s, decentralization has become a key policy priority. The General Law on Ecological Balance and Environmental Protection- the overarching Federal environmental law-and other environmentally related Federal legislation are complemented by State environmental laws. The shift towards greater decentralization requires the implementation o f short and long term approaches in all sectors including those involved in environmental management. However, cross-sectoral integration o f environmental considerations into economic decisionmaking has not been sufficiently deep and the evolution o f environmental policy implementation has not been accompanied by adequate capacity building at State and municipal levels. Complex decisionmaking frameworks do l itt le to promote sustainable water resources management in water-stressed northern and central States. Similarly, critical reforms to extend water pricing from municipalities and industrial users to the agricultural sector were rejected by Congress in 2001. Insufficient environmental competencies at the State and local level, combined with limited authority to raise revenues from taxes or other charges, impedes decentralization o f environmental management per federal and State laws.

49. Environment and Livelihoods. Mexico has a wealth o f natural resources which, if utilized in a sustainable manner, could serve as a driver o f growth in rural areas. With 1.3 percent o f the world’s land area, Mexico hosts about 12 percent o f known terrestrial biodiversity and i s one o f the world’s 12 megadiverse countries. Mexico’s forests account for over 100,000 permanent jobs and are home to 10 percent o f the national population. The country i s unique in that 70 percent or more o f i t s forest area i s within the boundaries o f ejidos and indigenous communities. Land tenure reforms in the 1990s gave many Mexican farmers titles to property, thereby providing incentives to increase productivity in agricultural and forestry activities and to consolidate small plots into viable farms. Innovative mechanisms to permit banking and trading o f water, as wel l as to increase operational and maintenance costs in irrigation districts, promote more efficient water use among users.

50. That said, Mexico’s natural resources have not been managed in a sustainable manner. Water resource management i s perhaps Mexico’s most urgent environmental problem today, and one that impacts heavily on the economy. The country i s slightly less than 2 mi l l ion km2 in size and the population has quadrupled from 25 mi l l ion in 1950, to 100 mi l l ion today. Population growth has occurred nationwide, but has been greater in the semi-arid and arid north, northwest, and central regions, which are precisely the regions with greater economic activity and where the major water shortage problems occur. Ha l f the volume o f abstracted

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groundwater i s pumped from overexploited aquifers. In 1975, 32 o f a total o f 653 aquifers were considered overdrawn; there were 80 by 1985 and 100 by 2002, accounting for over 50 percent o f the country’s groundwater supply. Priority issues to be addressed include: (a) over- exploitation o f surface and ground watg; (b) minimizinguse o f scarce water resource for low value crops; (c) lack o f a strategic consensus between key stakeholders; (d) inadequate water r igh ts administration (mainly due to over-allocation o f water rights); and (e) high subsidies for pumping groundwater and inappropriate pricing o f water.

51. In terms o f forest resources, Mexico suffers from one o f the world’s highest deforestation rates, around 1.2 percent per year. Based on preliminary information from the 2002 National Periodical Forest Inventory, approximately 770,000 hectares o f arboreal forest per year were lost between 1993 and 2000. Of this total, 66 percent takes place in tropical forests, including areas o f high biodiversity value. The loss in natural resources places a significant to l l on Mexico’s biological wealth: 2,582 species and subspecies o f birds, amphibians, reptiles and mammals are at risk, o f which 41 are probably already extinct in the wild, 1,215 are endangered or threatened with extinction, and 1,326 are subject to special protection. The main immediate causes o f deforestation and forest degradation are forest fires, illegal logging, extensive livestock production and clearing for agricultural purposes. Unsustainable agricultural practices have led to high rates o f soil erosion and desertification, which affect approximately 60 percent o f arable lands. Traditional and subsistence farming has contributed to environmental degradation, encroaching on forests and fragile land to boost agricultural production. Fishing i s the cause o f over-exploitation and diminishing populations o f many marine species o f commercial value, and thus o f the exhaustion o f fishing grounds and damage to marine ecological networks.

52. Environment and Health. Mexico has a relatively high incidence o f illnesses that can be correlated with environmental variables, especially among vulnerable groups (e.g., children, pregnant women, elderly). Such environmental variables include access to safe water supply and basic sanitation, as well as exposure to air pollutants, hazardous substances, and indoor air pollution in rural areas where wood-burning stoves are used. In short, while in recent years Mexico has made significant progress in reducing the health impacts o f pollution, efforts to diminish the impacts o f unsustainable development processes need to be consolidated and extended.

53. Municipal waste generation increased from 28 mi l l ion tons to 31.5 mi l l ion tons between 1993 and 2001, mainly reflecting rapid population growth, high rates o f internal migration and urbanization. Proper disposal capacity i s so inadequate that over ha l f o f municipal waste i s sent to uncontrolled and illegal landfills. Illegal dumping o f solid waste often results in improper operation o f sewerage and drainage systems, becoming a disease vector and creating public health risks. Local governments do not have the capacity for proper waste management.

54. In terms o f air quality, pollution levels have significantly declined overall in urban areas during the last ten years, including in Mexico City. However, relatively high emissions from industry, energy production and transport remain a challenge. Principal ambient air quality problems in urban areas include ozone and suspended particles, principally from fossil he1 combustion from industry and transport. As a result, while extremely high pollution episodes have become rare, the number o f days in which atmospheric environmental standards are exceeded has remained unchanged. While Mexico has assumed responsibilities

Municipal waste management i s at an early stage.

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earthquakes.

Box 4. Highlights of Government Programs to Promote Environmental Sustainability

Environmental framework. The 200 1-2006 Environment and Natural Resources Program (ENRP] provides a framework for the country’s environmental policy. The underlying pillars o f the ENRP include: (a) integrated ecosystem management: focus on ecological rather than pol i t ical boundaries in the management oi water, land, air quality, forests and biodiversity; (b) pol icy integration: sustainable development as the shared responsibility o f Federal ministries and institutions that represent distinct sectors o f the economy; (c) decentralized environmental management: shift the emphasis f rom prevention and control to stopping and reversing degradation o f ecosystems. This pol icy implies: (a) restructuring and decentralization o f the federal environment sector, calling for shared and coordinated environmental action across federal, State and municipal levels; (b) inducing good behavior on the part o f environmental users through clear, efficient and innovative regulation and the formulation o f incentives to promote efficient environmental performance; (c) provision and valuation o f environmental services: improve management o f natural ecosystems and ensure that those who benefit pay for these services; (d) enforcement o f environmental legislation: strengthen inspection and compliance; and (e) public participation and transparency.

Addressing water scarcity. The government has set goals for its programs supporting sustainable resource management. With respect to the National Water Program, milestones include: (a) the development o f a consensus on solutions to the water problem; (b) increase incentives for water conservation and increase resources for investments and management through increase and rationalization o f water fee collection; (c) improve water use and quality v ia better water rights and discharge administration, enforcement and through efficient water markets; (d) promote conservation o f water resources by redirecting subsidies and other financial resources on a pi lot basis; and (e) take an integrated approach to wastewater treatment that takes into account economic, social and environmental implications.

Promoting environmental health. Concerning environmental health, quantitative targets established under the 2001-06 Environmental Health Act ion Program include: 30 percent reduction o f respiratory illnesses due to exposure to atmospheric pol lut ion and 60 percent reduction o f those due to children’s exposure to indoor pollution; 15 percent reduction o f average population exposure to atmospheric pollutants; 70 percent reduction o f incidence o f high chi ld b lood lead levels; and a guarantee o f access to safe drinking water for 70 percent of the population. The 2002 version o f the annual Federal L a w on Water Taxes represented an important step towards securing investment finance. I t earmarked the revenue f rom abstraction and pol lut ion taxes for investment in water infrastructure, and made access to these fkds conditional on utilities agreeing to pay water taxes in the hture. A related initiative i s the Program for the Modernization o f Water Utilities, whose purpose i s to improve the operation o f these utilities in cities o f over 50,000 inhabitants and to attract private capital for financing new infrastructure. Waste management goals and targets are included in the Program to Ha l t and Reverse Air, Water and Soil Pollution. National targets primari ly focus on hazardous waste management.

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IV. THE WORLD BANK GROUP’S PARTNERSHIP STRATEGY

INPUTS TO DESIGN THE STRATEGY

56. The b of this CPS takes into consideration it vwiety o f inputs received from both internal and external sources. On the one hand, brainstorming sessions with local staff in the Mexico office and with WBG staff in headquarters were conducted at different stages o f preparation, before holding the formal Regional Brainstorming meeting in December 2003. Other internal sources taken into consideration were OED’s evaluations, the implementation o f the current program, and the valuable country knowledge existing within the Bank’s extended team working on Mexico. On the other hand, the government, c iv i l society, and other development partners provided key inputs to the strategy. In addition to working in partnership with the SHCP (the Bank’s main counterpart) this strategy was also discussed with other government institutions, including the Office o f the Presidency and sectoral Secretariats.

Country Partnership Strategy Evaluation and AAA Review

57. Mexico has been an important Bank client for decades. Especially over the past three administrations, beginning with the election o f President Salinas in 1989 and through the administrations o f Presidents Zedillo and Fox, the Bank had a substantial and wide-ranging program o f lending operations, analytical work, and policy dialogue. In 2001, OED issued a Country Assistance Evaluation (CAE) that assessed the program from 1989 through 2000. Although the climate for the Bank’s program in Mexico has changed in some important respects, many o f the lessons from that C A E remain valid today. In addition, the recently completed Country AAA Assessment (CAA) that covered analytical work during the FYO1- 03 period also provides important lessons to consider when we look forward.

58. An important lesson o f experience i s that although Mexico i s one o f the largest LBRD borrowers, the Bank i s only a marginal actor in Mexico. Bank lending provides a very small share o f public revenues and the government has ready access to alternative private financing. The Bank’s advice and analytical work i s one among many sources o f expert advice and analysis available to the government. This has two important implications. First, Mexico has exercised high degrees o f ownership in i t s relationship with the Bank. I t involves the Bank only in areas where it finds that the Bank can provide valuable assistance and where i t does not perceive excessive Bank conditionality. Second, in order to provide value-added in Mexico, the Bank has needed to do exceptionally good work, combining world-class international experience and analytical sk i l ls with deep knowledge o f the country and i t s institutions.

59. When the Bank has been able to adequately mobilize and manage i t s human capital, i t has contributed significantly to policy debate and formulation in Mexico and, through i t s lending operations, has aided effective implementation o f government investments and reform programs. In the last 15 years, the Bank has provided valuable assistance in defining and implementing investment programs and policy reforms in education, health, agriculture, transport, environment, trade, pension, and other areas. However, the Bank has not always been able to provide value-added, sometimes because the government has not accepted the Bank’s engagement. The recent AAA assessment found that although the level o f dialogue

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related to Bank’s analytical work was rated satisfactory, overall dissemination and strategic relevance were found marginally satisfactory.

60. The difficulties o f bringing non-financial value-added to Mexico certainly affected the Bank’s efforts to develop a lending program. The SHCP appropriately sets ceilings on the expenditure programs o f l ine ministries without regard to financing sources. Therefore, from the perspective o f a line ministry, a Bank loan does not add to i t s overall resource envelope. Because o f this “non-additionality”, the line ministries have often been hesitant to ask for Bank loans or accepted the technical assistance provided during loan preparation and then used non-Bank resources for project implementation. They are concerned about the “hassle factors”-Bank procurement rules, audits, and safeguard requirements. On the other hand, some ministries, where the Bank’s work i s better known, welcomed and benefited from the Bank’s involvement through lending operations.

61. According to the OED CAE, l ine ministries found that the Bank could have value- added by: providing first-class policy analysis; giving an objective, outsider’s perspective; sharing lessons o f international experience; using the Bank’s convening power to bring about more productive dialogues among Mexican stakeholders; inducing greater coordination among units o f the government; insisting on technical norms for resource allocations that might otherwise be subject to excessive political manipulation; and injecting a greater measure o f discipline in project execution. However, if a l ine ministry has not had a sustained, productive relationship with the WBG within i t s institutional memory, i t may not perceive that these potential contributions are worth the “hassle factors”. This suggests that, in defining its portfolio o f activities in this CPS, the WBG should focus on areas where i t already maintains productive relationships (or i t can quickly start them) or where the WBG can employ the best expertise (either i t s own or external) to help policy-makers deal wi th difficult questions. Moreover, the C A A panel specifically recommended that the AAA program should be organized around a few organizinghnifying principles such as: (a) competitiveness; (b) poverty reduction; (c) infrastructure, including water and sewerage services; and (d) modernization o f institutions. The panel also stated, “In Mexico, accept that AAA work and lending are more separated than i s normally the case. AAA i s more clearly an end in i t se l f in a middle income country such as Mexico than in most countries.”

62. Historically there has also been a political aspect to the Bank’s reception in Mexico. The Bank’s name evoked suspicion or even hostility from some elements o f Mexican society. For this reason, even Mexican leaders who consider the Bank’s analytical work and publications a valuable source o f ideas (Global Pol l results in Box 6) s t i l l worried that the Bank’s association with certain sensitive reforms would be politically harmful. Even in areas that were less politically sensitive, the govemment was sometimes reluctant to accept the Bank’s public embrace. This may, in part, explain why overall dissemination o f analytical work was found marginally satisfactory by the CAA. As policy debate and political competition in Mexico have become more open and democratic, these concerns are diminishing (Messages to the Bank from Civ i l Society in Box 5). Nevertheless, the Bank must s t i l l be aware that public endorsement o f certain programs and reforms might damage their political viability-especially as the next, highly contested election approaches.

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Program Implementation

63. IBRD’s efforts to assist Mexico during the FY03-05 CAS were organized under five strategic objectives: (a) consolidating the macroeconomic framework; (b) accelerating growth through competitiveness; (c) human capital development; (d) balancing growth and poverty reduction with environmental protection; and (e) building an efficient, transparent, and accountable government. The program included a r ich program o f analytical work and offered a three-year US$5 bi l l ion lending envelope; however, annual new commitments were only US$1.2 bi l l ion in FY03 and are expected to be below US$l.O bi l l ion in FYO4- equivalent to an annual US$l .O-1.2 bi l l ion envelope-mainly because major pension, highway financing, and development banks reforms did not materialize as expected. As o f February 29, 2004, the Bank’s exposure in Mexico was US$10.5 billion, representing 9.2 percent-second la rges t -o f the Bank’s total portfolio. During the f irst six-months o f FY04, the disbursement ratio o f the Mexico portfolio reached 13 percent-in l ine with the average disbursement ratios presented in the previous four fiscal years. The portfolio under implementation comprises 17 lending operations (see Annex BS) for US$3.6 bi l l ion in commitments o f which US$2.3 bi l l ion are s t i l l available for disbursement (5 loans are managed by ESSD, 7 by FPSI, 3 by HD and 2 by PREM). Two operations represent actual risk for an undisbursed amount o f US$724 million. The Bank also manages 7 full-size GEF/PCF operations with only one at risk. This i s the largest GEF portfolio in the Bank.

64. In order to monitor portfolio implementation, the Colombia and Mexico C M U established an Implementation Team comprised o f Resource Management, Procurement, Operations and Financial Management staff during FY03. The team’s main goal i s to generate a broad view o f portfolio management and supervision among al l operation support units and within the department’s management team. One o f the f irst tasks implemented by the new team was a Country Portfolio Performance Review (CPPR)-the f irst one done in Mexico since M a y 1997-with the active participation o f our government counterparts, as well as financial agents and executing institutions. The main issues identified during the exercise were the generalized delays in effectiveness, the lack o f budget prioritization at the sector level, the absence o f efficient financial intermediation to implement loans at the decentralized level, the excessive number and not properly planned Bank missions visiting Mexico, and the need to decentralize Bank staff (including legal and safeguards) to the country office in order to improve project supervision. While there has been progress on many o f the agreed improvement actions, some o f the main issues-such as budget prioritization, financial intermediation, and decentralization o f Bank staff-ontinue to affect portfolio implementation. The next CPPR i s planned for M a y 2004 and, in addition to lending operations, we are planning to include a review o f non-lending activities. This should help the country team systematically address the weaknesses identified in the February, 2004 Country AAA Assessment.

65. Financial management in the Bank’s Mexico portfolio i s generally sound, supported by the involvement o f numerous established government institutions, including national development banks, the government’s internal audit office (SFP), and executing entities. Project funds pass through government budget processes, and Bank financing is usually provided as a reimbursement o f expenditures. This arrangement has worked well, except that in some projects in which funds f low to multiple entities or levels, i t has been slowed by insufficient inter-institutional management arrangements and/or cumbersome reporting

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requirements imposed by each institution or level involved. The Country Financial Accountability Assessment (CFAA), completed in 2003, confirmed the general strength in the federal public sector’s financial management, but pointed out certain key weaknesses such as fragmented information systems and the relative inexperience o f external oversight functions. Overall, experience on projects and the findings o f diagnostic work carried out suggest substantial opportunities to place even greater reliance on government institutions (e.g. those related to funds flow, reporting, and audit) in the financial management o f Bank programs, while at the same time supporting capacity building efforts where weaknesses exist. This approach will need to be customized to the particular institutions involved, especially for Bank-financed programs in which funds may be managed by subnational level institutions, where financial management capacity levels may vary considerably.

66. One area that has a major impact on the results o f public expenditure i s government procurement and contracting. The Country Procurement Assessment Report (CPAR) issued in 2002 highlights the strengths and weaknesses o f the Mexico legal and administrative public procurement framework and makes specific suggestions to improve it. In terms o f Bank- assisted projects, the CPAR found that agencies responsible for project implementation carry out procurement in accordance with Bank policies and procedures, using i t s standard bidding documents. Procurement performance in Bank projects was therefore concluded to be satisfactory and free o f major problems-2 procurement audits and 10 agency procurement capacity assessments carried out in the past two years found no major problems either. The most used procurement method i s NCB, and in the majority o f the I C B procedures only Mexican f i r m s submit bids. The CPAR also defined a Plan o f Action to strengthen procurement at the federal level. The SFP and the Bank have met every 3 months to follow up on agreed actions-about 80 percent have been completed. The SFP has made a significant effort to organize, standardize and even deregulate public administrative and procurement law-the wide variety o f rules and regulations affecting the current procurement regime results in dispersed, fragmented and, at times, contradicting normative bodies. For instance, more work i s required at the State level to improve contracting procedures and discard those which do not follow generally accepted principles. Modifications to the two procurement laws (one for goods and one for works approved in 2000) to make the system more efficient and transparent are already before Congress. Taking into account the progress so far, the SFP and the Bank have agreed to prepare a Second Plan o f Action with the intention to move to country systems in the area o f procurement at the federal level during this CPS period.

67. IFC’s strategy during the past CAS period centered on (a) fostering financial sector development; (b) enhancing international competitiveness o f the private sector; (c) promoting investments in areas newly opened for private sector participation; and (d) promoting sustainable development and good corporate governance. In this period, IFC has committed U S 5 8 5 million, including US$207 mi l l ion in syndication, to projects in general manufacturing and services, infrastructure, financial, information and technology, municipal finance, mining and agribusiness sectors. IFC’s investments during this period have had a development impact in various fronts, for example: (a) help preserve/create jobs in viable companies by providing long-term funding not otherwise available to these companies hence avoiding scaling down operations; (b) through i t s sustainability initiative, transfer knowledge in and assist in implementing global best practices o f environmental management and corporate governance to its customers; and (c) support investments geared toward providing

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basic needs such as water and housing for lower income people; (d) and promote local SMEs through SME linkage programs. IFC continued to expand to new areas especially with its f irst municipal finance operation. Through this innovative operation, IFC is providing a peso- denominated partial guarantee to a private Mexican trust, which will issue bonds in the local markets. The proceeds will be used for a wastewater treatment plant to be built by the Municipality o f Tlalnepantla. IFC also provided financing to a leading Mexican producer and distributor o f paper-based consumer products in Mexico, Nicaragua and Costa Rica. With debt coming to maturity, market contraction has presented the company with a major liquidity problem. IFC’s support i s helping the company overcome this problem as wel l as improve i t s corporate governance practices. Annex C 1 includes a detailed description o f IFC’s activities in Mexico during the previous CAS period.

68. As o f December 31, 2003, Mexico represented the sixth largest exposure in terms o f outstanding balance for IFC’s own account, representing 4.9 percent o f IFC’s total disbursed portfolio. IFC’s portfolio in Mexico consisted o f investments in 52 companies in a broad range o f sectors, for a total exposure o f US$614 mi l l ion for IFC’s own account and US$383 mi l l ion for participants. In light o f the 2001 economic slowdown and declining capital flows, the previous CAS highlighted the importance o f quality at entry o f new projects to preserve a healthy portfolio. Through i t s selectivity, IFC has identified and participated in good investment opportunities that have helped maintained the high quality and performance o f the portfolio. This has been done while continuing IFC’s focus on frontier sectors. As a result, as o f mid-FY04, only 1.7 percent o f IFC’s loan portfolio was in non-accrual status.

Messages Received from Civil Society and the Global Poll 69. As part o f the CPS preparation, the Bank organized three full-day seminars with diverse members o f c iv i l society, including participants from academic institutions, business chambers, indigenous groups, unions, non-governmental organizations and the private sector. The events took place in Oaxaca, Mexico Ci ty and Guadalajara. The main message heard from c iv i l society (see Box below) was that the Bank should remain very actively engaged in Mexico. The dialogue helped the Bank to better understand the development challenges facing Mexico and define the role we should play to provide more valuable assistance.

Box 5. M a i n Messages Received from Civil Society

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70. The Global Poll, carried out for the Bank by Princeton Survey Research Associates, i s one o f the largest and most comprehensive surveys ever conducted on international development issues with opinion leaders4. The results in Mexico are consistent with the main messages received during CPS consultations. Opinion leaders were asked about the WB’s role in international development, and i t s performance in key areas. In Mexico, opinion leaders believe the Bank should concentrate efforts on reducing poverty, promoting growth and the economy, and ensuring environmental sustainability. Poverty reduction i s the top priority in all categories, while growth and the economy appear as the second priority for the country and Bank objectives. Mexico is the only L A C country to rank environmentally sustainable development as the second area where the WB should spend more resources and as one o f the top three WB objectives. Mexican opinion leaders also regard poverty and inequality as significant problems and recognize the importance o f being competitive in open markets. In addition, they consider the Bank’s analytical work and publications a valuable source o f ideas.

3. Corruption (17%) I 3. Building climate for investment (12%) Opinion Leaders’ Views on Social and Economic Issues 0 Pessimistic about current economic situation and social problems. A majority (57 percent) thinks the

biggest problems facing Mexico are social in nature (poverty being the main issue). Economic problems are second in importance (25 percent). In favor of globalization, privatization, and greater openness. Globalization i s seen as good by 80 percent (highest response among L A C countries), while 72 percent think privatization o f inefficient State-owned enterprises wil l have a positive effect on Mexico. Open markets and trade, the establishment o f foreign businesses and companies, foreign products, ideas and culture are considered good by 75 percent or more. Gap between rich and poor widening. A majority (85 percent thinks the gap between r i ch and poor people i s widening in Mexico, compared w i th 3 percent who perceive it has decreased. All respondents believe the gap between r i ch and poor countries i s widening as well.

I 3. Environment (1 5%)

- Opinion Leader’s Views on Bank’s Studies and Dissemination 0 Greater effectiveness and exposure. 85 percent o f Mexicans (best response in LAC) believe Bank

communications have become more effective. A majority (60 percent) feel they are exposed to more information about the Bank than in the past and 58 percent are exposed to information about the Bank at least

Usage o f Bank information i s high. In Mexico, publication usage i s the highest among L A C countries polled: 82 percent has used a Bank publication in the last two years. Mexicans are also the heaviest users of Bank sources o f information: 66 percent get their information about the Bank f rom Bank web sites, publications, reports, and face-to-face meetings, while 27 percent get their information f rom newspapers. The external web site in the U.S. i s used four times as much as the locally accessed web site, but 42 percent use Bank web sites infrequently (once or a few times per month).

0 Publications are helpful. Those who use publications find them easy to use (97 percent), up-to-date (85 percent) and helpful (89 percent think the Bank‘s Public Information Center i s a valuable source o f information). Users think Bank publications effectively contribute to the country’s economic debate (85 percent) and acknowledge they have an important influence on their thinking about development issues (84

High level of icers f rom government, media, c iv i l society, academia, private sector and labor unions.

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Development Partners’ Activities

71. One o f the WBG’s main development partners in Mexico is the Inter-American Development Bank (IADB), which i s planning to deliver a US$O.8-1 .O billion, 4-5 operations a year program to support the country in three main areas: (a) Competitiveness, through the reform o f the rural credit system, an effort which builds upon a tradition o f collaboration between the IADB and Bank in support o f the reform o f the private and public financial systems and would continue with similar operations in the future; (b) Social Development and Poverty Reduction, through operations such as Oportunidades, Habitat, community education at the primary level, labor training, water and sanitation, and improvement o f the delivery o f health services and reform o f the pension system, an operation which would also be carried out together with the Bank; and (c) Institutional Strengthening, mainly through support for improved governance at the State and Municipal levels through BANOBRAS. Although IADB has limited resources for analytical work, at the policy level, we maintain continuous communication on economic and social developments in the country.

72. At the moment, Mexico does not have a financial support program or loans outstanding with the IMF and in view o f the country’s healthy finances, it i s not expected to request Fund support over the CPS period. Therefore, the IMF recently closed i t s office in Mexico. The Mexican government does, however, maintain an active policy dialogue with the IMF through the Fund’s bilateral and global surveillance activities, including annual Article IV consultations. IMF and Bank staff maintain regular contact on macro policy. In addition, the Fund provides technical assistance in areas such as the assessment o f financial, fiscal and economic data quality and dissemination practices in observance o f internationally recognized standards and codes.

73. While there are not many other donors working in Mexico given the country’s income level, there are a few other development partners active in Mexico. The Bank maintains a continuous dialogue with the OECD on economic analytical work, as well as with the local United Nations system, which has twenty agencies in Mexico supporting government efforts related to each agency’s specialization with stronger concentration in HIVIAIDS, gender, human rights, and the MDGs. In addition, the Bank has recently initiated contacts with (a) the U.S. Agency for International Development (USAID) that has a US$30 mi l l ion a year grant program to support democracy and govemance, prevention and control o f infectious diseases (TB and HIV/AIDS), management o f natural resources, broadening access to finance for micro-enterprises and higher education partnerships; (b) the Japan International Cooperation Agency (JICA) that has a US$30 mi l l ion a year technical cooperation program in disaster prevention, technical training, industrial and regional development, health and environmental protection; and (c) some other bilateral partners which have trade promotion activities in Mexico. The matrix below shows the areas where Mexico’s development partners are active.

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Strengthen Institutions Environmental Promote

Development Reduce Poverty Increased Strengthen Institutions Environmental Challenges & Inequality Competitiveness Sustainability

Partner

I

I OECD I I I I I I Other Bilateral I I I I I

High Focus Significant Focus Some Focus

Mexico’s Debt Management Strategy 74. The government’s debt management strategy over the CPS period i s expected to remain in line with i t s current approach of: reducing the foreign-currency debt as a proportion o f the total; reducing the costs o f foreign debt; and extending the maturity profile o f a l l debt. This i s being achieved by financing the fiscal deficit in the domestic market, while using foreign-currency borrowings for refinancing purposes only. Development o f the domestic market and lengthening o f the yield curve has allowed for coverage o f the government’s financing needs and extension o f the average life o f domestic debt. On the external front, the strategy i s to improve the maturity profile, reduce costs by retiring collateralized debt, diversify the investor base, and reduce vulnerability to the uncertainty o f the international capital markets.

75. The level o f public debt, in the traditional definition, as a percentage o f GDP decreased substantially since the mid- 1990s. However, including extra-budgetary liabilities stemming from the banking crisis (IPAB), toll-roads bail-out (FARAC) and private sector financed investments in the energy sector (PIDIREGAS), the historical balance o f the PBSR continued in a range o f 40-45 percent o f GDP over the past few years, as shown in the following graph.

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Figure 2. Total Net Debt of the Public Sector Stocks outstanding at end o f period as Percentage o f GDP

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76. The sources o f financing have also changed since the mid-1990s crisis, with a significant expansion o f market debt in both MXN and foreign currencies and a reduction in bilateral, multilateral and restructured debt. Debt outstanding from the IADB and IBRD has been reduced by US$1.1 bi l l ion since 1995 and currently represents US$17.5 bi l l ion or 11 percent o f Mexico's external debt. Mexico does not have any outstanding obligation wi th the IMF. This has generated and, if the current trend i s continued, will continue to generate MDBs lending space-"headroom" within exposure guidelines. MDB lending presents some advantages over private sources: stability in spreads, access in time o f international market constraints, and technical advice usually provided with financing.

77. The government's successful debt management strategy implemented since the mid- 1990s has resulted in a marked improvement in some risk indicators. In particular, foreign- currency debt (including debt linked to foreign currencies) has fallen f rom 75.3 percent o f total net debt at the end o f 1995 to 38.8 percent at present (including PIDREGAS debt). Over the same period, the average maturity o f gross domestic federal debt has increased from 0.8 years to 2.5 years (excluding off-balance sheet liabilities, such as IPAB and FARAC, for which figures were not readily available). The average maturity o f foreign-currency debt i s estimated to have fallen since the mid-l990s, with the prepayment o f very long-dated collateralized debt. Federal gross debt (excluding off-balance sheet debt) maturing within the next 12 months has not changed considerably over the period and currently represents 13.5 percent o f the total.

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PROPOSED STRATEGY AND INSTRUMENTS

78. This CPS will focus in supporting the government’s efforts to reduce poverty and inequality, increase competitiveness, strengthen institutions, and promote environmental sustainability in Mexico. This section presents f irst a discussion o f the WBG’s thinking on how its relationship with Mexico i s evolving and why it should remain active in the country; a description o f the WBG’s comparative advantage and strategic focus; and the Bank’s lending cases. The next four parts describe the WBG’s lending and non-lending instruments proposed to deliver the strategy organized under the four CPS pillars. The last part o f this section presents the Bank’s financial instruments proposed to support Mexico’s debt management efforts.

79. Mexico-as evidenced by its per capita income o f about US$5,900 (GNI per capita under Atlas method)-is in an advanced stage o f i t s development and the WBG’s strategy needs to take this into consideration. This CPS proposes a greater focus on the role that the WBG can play as a knowledge institution, while continuing to deliver a program o f lending operations consistent with Mexico’s development needs. In the next four years, the WBG can make more o f a difference in those areas where i t already maintains productive relationships wi th government counterparts, where challenges are multisectoral in nature and where there remain difficult unresolved matters. I t can also be the honest broker among government institutions and c iv i l society in their efforts to deal with development issues. Taking into consideration these advantages, we will seek a sustained programmatic analytical engagement in selected areas where the WBG can have the greatest impact, such as poverty, competitiveness, education quality, decentralization o f public finances, and sustainable water management. Our analytical and learning assistance in these areas would be supported by lending, including programmatic SWAPS, at the request o f the government. In addition, given the importance o f supporting State governments for the development o f Mexico, the authorities and the Bank will continue discussing potential opportunities to increase lending and non-lending assistance to the States. These discussions could lead to a request for additional lending.

Transition to a New Relationship 80. Mexico has access to international financial markets, to the U S market through NAFTA, and i s a member o f OECD and the World Trade Organization (WTO). It is an IBRD country with investment grade, which has a significant lending program with the Bank. Its recent democratic transition has received widespread recognition and has launched greater public demand for transparency, accountability, and decentralization. With these enviable assets, what is the comparative advantage o f the World Bank in Mexico and at what point should the country seek graduation?

8 1. The WBG’s role i s determined by the significant poverty challenge in Mexico and the value that the government places on our contribution. According to official poverty figures, over 50 percent o f Mexico’s population i s s t i l l poor. This i s in large part because Mexico suffers from great income inequality (the richest tenth earns over 40 percent o f total income, while the poorest tenth earns only 1.1 percent), deep regional and ethnical disparities (such as nortldsouth, indigenoushon-indigenous), and differences in access to quality healthcare, education and public utilities. Moreover, achieving some o f the MDGs by the year 2015 will be a challenge for Mexico. With no further changes in income distribution and current

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estimates o f an average yearly growth rate o f 3.5 percent o f GDP, Mexico i s unlikely to meet the goals o f reducing extreme poverty by halfY5 under-five mortality by two-thirds, and maternal mortality by three quarters. I t is estimated that Mexico needs a sustained growth rate o f 5 percent, which has not happened since the 1 9 7 0 ’ ~ ~ in order to achieve the extreme poverty MDG (see Table 2).

82. In response to the expressed desire o f the Mexican government, which we also heard loud and clear in our consultations with civil-society, the WBG expects to stay engaged in Mexico to continue supporting the country’s efforts to tackle its development challenges and achieve the MDGs. The engagement proposed in this CPS seeks to respond to the specific requirements o f Mexico.

World Bank Group’s Comparative Advantage and Focus 83. Learning from the implementation o f the previous CAS, and adapting to the challenges posed by a middle-income country such as Mexico, this CPS will attempt to have a greater development impact through sustained involvement in selected areas, through the use o f all the available Bank instruments. This adaptation starts by recognizing that the most important value-added o f the Bank i s not in transferring resources but in helping Mexico achieve better development effectiveness through targeted analytical work and improved project and policy design.

84. Our clients have stated that the main value-added the Bank has in Mexico i s through analytic work in those areas where: (a) there are difficult questions; (b) inter-sector work i s required; and (c) we are perceived as a neutral player. I t i s through enhanced programmatic analytical work that we can raise important development issues, promote debate by different stakeholders and bring to Mexico the experience o f other countries which have faced similar constraints. Our value-added has been less clear to the Mexican government in some o f our lending operations, given the constraints posed by the government’s non-additionality and the Bank’s conditionality. Moreover, our record in the last 8 years shows that many lending operations in the previous CAS never materialized. Since FYO1, we have delivered an average o f 4 lending operations per year despite having 10-12 operations under preparation and offering 11-12 new lending operations per year in the previous CAS.

85. Therefore, in this CPS we propose that our emphasis would shift, together with our budget resources, towards an enhanced program o f analytic work. However, while the Bank’s potential value-added comes from i t s knowledge and analytical contributions, it i s important to keep in mind that i t s effectiveness (convening power, policy influence, etc.) i s s t i l l closely tied to lending. Thus, this strategy proposes a more strategic way o f bundling Bank analytical instruments to provide analytical support in key areas o f opportunity, while at the same time strengthening the Bank’s lending support in core areas where i t has already established productive relationships (for example, poverty reduction, education, health, water resources management, irrigation, and forestry) and in other areas where we intend to make a significant contribution to critically important government programs (for example, justice, property rights, access to financial services, and environmental management). Within a constant budget scenario, this would imply less overall resources devoted to overall project preparation, and a lower number o f operations in the pipeline, but not necessarily fewer

The off icial numbers show an improvement in income distribution between 2000-2002, but it i s s t i l l unclear whether the trend wil l be sustained.

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operations delivered or less budget per operation. We propose to provide financial resources through 4 to 6 operations a year, including a m i x o f policy-based operations, SWAPS and investment loans. The proportion o f quick disbursing loans will depend on the implementation o f reforms as wel l as on maintaining the Bank’s exposure limits.

86. On the knowledge front we would give priority to areas where answers are not readily available and where the Bank can employ the best expertise to help policy-makers find answers to difficult questions. We have selected a few strategic areas for programmatic AAA work, which would help the Bank: stay engaged in a core issue area over the full CPS period; build longer-term relationships with key national counterparts within and outside the government; enhance i t s staff knowledge o f Mexico’s situation and institutions so as to improve their potential value-added; use the full range o f Bank products (formal reports, informal papers, conferences, workshops, dissemination activities, IDFs, learning programs, and fee-for-services-an area where we have recently had positive experiences working with government institutions); and create the foundations in terms o f knowledge and institutional relationship for lending operations in which the Bank can have non-financial value-added. The areas where we currently see these opportunities within each o f the themes o f this CPS are: poverty, competitiveness, water, and education quality. Decentralization could be the fifth area given the new opportunities posed by the recently launched Convencidn Nacional Hacendaria, a national convention being convened to discuss federal, State and municipal policy and interrelations.

87. The programmatic approach will require that we work in thematic clusters, under the leadership o f our locally based Sector Leaders, to provide for multi-sectoral, multi-operational and extra-institutional expertise in longer-term partnerships with the government and other partners (including IADB, USAID, JICA and others) to tackle Mexico’s main development challenges. Working in thematic clusters with such characteristics should promote consensus building, strengthen policy recommendations, and improve project and sectoral strategy design, delivery, and monitoring. This approach requires a human resource strategy that allows us to convene the best expertise we can muster as a knowledge institution. I t also means that we will need staff who work together effectively as a team and have a shared understanding o f the struggles faced by the poor and vulnerable. In order to launch this effort, the C M U sponsored a retreat for 86 staff during which we spent a day in indigenous villages close to Oaxaca City, Mexico. Divided into 11 groups, we learned about the development issues poor communities encounter, especially in light o f the MDGs; we heard the voices o f the poor and gained a better understanding o f the uniqueness o f each community (shared language and culture, patrimonyhnique products to market, access to roads and markets, government, partner and Bank programs that exist). The following day each group presented i t s findings in poster sessions (similar to the Development Marketplace). We shared with each other the impact o f our experience, as well as how the lessons we had learned could shape our work and help us better implement this CPS.

88. To attain a more effective dialogue with, and expose the Bank’s knowledge resources to key audiences-both in government and c iv i l society-in a systematic manner, an effective outreach and dissemination strategy has also been outlined. In addition to working in the areas identified in the Global Pol l and in consultations with c iv i l society, this strategy entails (a) enhancing the Bank’s participation in conferences and public debates; (b) upgrading, expanding and promoting the Public Information Center; (c) further developing the Mexico

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external website; (d) expanding outreach to include a greater number o f key media people, academics, NGOs, politicians business people, etc; and (e) ensuring better dissemination and visibility o f Bank publications, specially in Spanish. The C M U will further strengthen i t s Outreach Team, including the Public Information Center, to implement this strategy.

89. Improving the Bank’s competitiveness in Mexico also requires moving to country processes in procurement, financial management and safeguards-consistent with the recent Bank’s efforts to enhance i t s support to middle-income countries. Under this approach, the Bank would rely on federal and applicable subnational systems and institutions for financial management and procurement under Bank-financed proj ects-national procurement procedures and standard bidding documents would apply to procurement processes where appropriate. On safeguards much has been done in Mexico to level i t s norms and regulations to international standards. Thus, the Bank’s intention i s also to move towards relying on and using country systems for environmental and social safeguards in this CPS period. In this direction, a review o f the Mexican environmental and social standards legal and regulatory will be conducted to assess relevant gaps between Bank safeguard policies and those embodied in Mexican law, institutions and practices. Consequently, upon submission to the Board o f any new operation under the country fiduciary and safeguards systems approach, the corresponding project documentation will (i) clearly identify relevant differences between Mexican and Bank policies and procedures, and (ii) request the Board to approve the relevant operation to be carried out in accordance with the identified Mexican policies and procedures. In support o f these efforts, relevant due diligence analytical work is focusing on specific steps to move towards increased reliance on country systems and will be undertaken in close collaboration with key counterpart institutions in a fashion that emphasizes not only their diagnostic objectives, but also the capacity enhancement aspect. Attention will be given to strengthening country processes at both the federal and subnational level.

90. In Mexico, as in other middle-income countries, demand for IFC services fluctuates with the extent o f i t s comparative advantage vis-&vis other sources o f financing and know- how available for the private sector. IFC’s advantages in Mexico l i e primarily in specific transactions, catalyzing financing where IFC’s presence adds value. IFC’s strength i s derived from its practical knowledge o f the financial and corporate sectors, dialogue with international and local private investors, hands-on experiences in local constraints to private investment, and accumulated international knowledge and expertise. Also, given the current difficulties to proceed with needed reforms, i t can be expected that both lenders and investors will exercise more caution and will be more selective in the future. In this, IFC will engage where feasible in new opportunities where i t can play a catalytically role in mobilizing funds that otherwise wouldn’t materialize, hence assisting companies improve their competitiveness. Mexican top f i r m s in good financial standing have enjoyed access to external financing for some time and with the country attaining investment-grade credit rating in early 2002, this access has further improved for large firms. However, external financing to al l the private sector has not materialized as originally envisaged. Second t ier companies, as wel l as larger corporations that have suffered from economic slow-down, find it difficult to refinance their external debt, thereby limiting their capacity to invest and to remain competitive. This refinancing risk was identified in the previous CAS. IFC has a role in supporting the corporate sector by providing long-term financing accompanied by expertise in environmental and social issues and know- how geared to improve competitiveness.

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Lending Scenarios and IBRD’s Exposure 91. The SHCP and the Bank have agreed to work in partnership during this CPS period (FY05-08) to implement a lending program that best addresses Mexico’s development needs as a creditworthy middle-income country and enhances the Bank’s ability to respond quickly to changing circumstances. A lending range o f US$0.8 to US$1.7 bi l l ion a year i s proposed in order to promote the country’s key development objectives supported through this CPS. The proposed lending range i s consistent with careful risk management, in view o f the government’s sound macroeconomic policies, i t s prudent debt management strategy to contain the overall public debt as a percent o f GDP and reduce the currency exposure (see par. 74 above), and the projected evolution o f Bank exposure.

92. Within the above range, IBRD’s most l ikely lending scenario would be about US$1.2 bi l l ion a year which assumes continued sound macroeconomic and social policies and portfolio implementation, as wel l as a stable external environment, and reflects the government’s strategy to take advantage o f the current favorable market situation to further reduce i t s external debt exposure. Taking into consideration the average annual amortizations o f US1.4-1.5 bi l l ion in the coming years (assuming no prepayment o f IBRD loans during that time), Mexico’s current exposure with IBRD o f U S 1 0 . 5 bi l l ion (as o f February 29, 2004)-9.2 percent and second largest share o f I B R D ’ s portfolio-would fa l l to US$9.2 bi l l ion or 7.8 percent o f I B R D ’ s portfolio during the period o f the CPS. Under this scenario, Mexico would continue to meet al l Bank exposure guidelines and would gain “headroom” within them, so that the lending program could move to the upper limit o f the borrowing range and would s t i l l remain within the IBRD exposure guidelines, including the single borrower ceiling o f US$13.5 billion.

93. The Bank’s program would move to the higher end o f the lending range to assist the government in i t s efforts to:

undertake policy measures to address the impact o f unexpected economic shocks or contagion effects emanating from international capital markets;

implement accelerated or broader reform programs as outlined in the government’s development agenda in areas such as fiscal management, energy, labor, pensions, development banks, telecommunications and justice (see paragraph 5); and/or

finance new or enhanced investment programs, including increased lending at the subnational level and/or new lending opportunities, which may arise as a result o f the programmatic analytical work proposed in the CPS.

94. The Bank’s program would move to the lower limit o f the lending range if (i) the government chooses to further reduce its new borrowings and exposure to the Bank; (ii) the government does not maintain sound macroeconomic and social policies, which may be evidenced by a deterioration in the PSBR or a fa l l in the ratio o f social expenditures to federal government programmable spending; or (iii) portfolio performance deteriorates significantly. Under the highly unlikely scenario o f major departure from sound macroeconomic policies, the Bank would respond by reducing lending volumes even below the lower-end o f the proposed borrowing range. Furthermore, in the event o f any significant changes in the proposed strategy, we would prepare a CPS Progress Report for discussion by the Board.

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Instruments to Reduce Poverty and Inequality

95. The programmatic approach to AAA has already started in the poverty work. In response to a request from President Fox, the Bank has started assisting SEDESOL and the Social Cabinet in i t s effort to systematically address poverty issues through analytical work and facilitating dialogue with international experts. Under this programmatic approach, the ongoing Poverty Programmatic AAA (which includes analytic work and capacity building activities for the duration o f this CPS, FY05-08) will provide an overall diagnostic o f the government’s poverty framework (CONTIGO), in-depth work on mralhrban and income poverty, as well as social protection in a f irst phase. In i t s following phases, it will focus on institutional issues, especially in the context o f service provision and decentralization, and on an overall synthesis particularly concerned with supporting the transition to the next sexenio. To enhance i t s relevance, we have agreed with SEDESOL on a program o f jo int dissemination and debate o f the poverty work that will include discussions among the Executive and Congress, as wel l as engagement with the States. At the same time, a programmatic review o f public expenditure i s analyzing in greater depth the incidence o f public spending-including social investment-both at the federal and the State level (see institutions section ahead). The executive branch wants to use the PER as an instrument in their budget discussions with Congress. Both programmatic A A A s could provide the basis for a policy-based operation for poverty alleviation (Contigo SAL in FY06) that may involve, for example, a rationalization o f government programs based on their impact on poverty alleviation and potential support for the IMPULSO strategy. This approach would be complemented with the ongoing work on Monitoring and Evaluation (IDF) with SEDESOL and with WBI’s learning programs in social evaluation, results-based management, achieving MDG targets and quality and equity in learning, among others.

96. While our programmatic approach will require multi-sector teams from both the Bank and the government and will provide the overall framework for our support, we will also undertake sector-specific analyses when more specific dialogue requires i t and sector lending when sector institutions need to implement policy or institutional change on the ground. In the poverty pillar, such sector-specific lending would focus on targeted programs seeking to include the poor in social services both on the supply and demand sides, through existing projects in health (PROCEDES) and education (Basic Education Development IIIIFY04). PXOCEDES, already approved, would be restructured to support the government’s Seguro Popular program, and retrofitted as a SWAP. Analytic work on service coverage and quality Health Service Delivery (FY05-08), as wel l as public expenditure efficiency (IMSS Study in FY07), would provide the basis for a Health System Support lending operation in FY07. In developing new investments in the health area, IFC will also seek opportunities to work with potential clients that, among their activities, seek to expand service coverage to underserved, lower income areas, as in the case o f an on-going investment in Mexico City. Review o f determinants o f the Quality of Education (FY05-08) would be addressed through programmatic analytical work in collaboration with the government, with a particular focus on the poor and indigenous populations. Among the more promising interventions i s the PEC (Programa de Escuelas de Calidad) which promotes school-based approaches to quality enhancement. Bank support for scaling up this pilot will be carried out through an Education Quality SWAP project in FY06.

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97. Efforts at poverty reduction and increasing the equity o f public spending will also need to include the States, which have responsibility for health, education and infrastructure. Dissemination o f the Southern States Development Strategy (SSDS) i s spawning requests from southern States for greater engagement with the Bank. Our init ial response, pending the results o f the Convencibn Nacional Hacendaria, i s to develop an intensive and collaborative program o f capacity building and knowledge sharing through the WBI, which would focus on public finance management and economic and social accountability at the State level.

98. Finally, we plan to be involved in series o f lending operations supporting the government’s efforts to strengthen access o f low-income people to assets, notably housing and land. We are ready to put a series o f operations together, based on the ample analytic work already done, to provide Housing and Urban Programmatic Sector Policy-based and Technical Assistance Loans (FY04+06+08). These would target reforms and actions in the areas o f policy, institutional frameworks, housing subsidies, household savings and privately provided finance for housing, urban land markets, and urban upgrading. IFC’s work in housing complements wel l with that o f the Bank, i t has benefited from coordination with the Bank and i s expected to continue to increasingly do so. IFC’s growing activities in the sector will encompass investments and technical assistance that, among i t s key priorities, will help increase private financial institutions capacity to provide market rate mortgages to low income market segments, thus reducing the level o f direct lending o f the government entities for mortgage. In rural areas, we will support the govemment’s program through the current Municipal Development in Rural Areas project in addition to studies o f Land Reform in FY05 and Rural Decentralization in FY07 and a loan to provide Access to Land for Young Farmers in FY06.

99. To facilitate inclusion, especially o f indigenous groups, the Bank has IDF grants supporting the c iv i l society training activities o f INDESOL and the indigenous outreach activities o f CONADEPI. To promote inclusion with equality for women, the Bank has a Gender LIL under implementation and could continue supporting the Institute for Women and i t s agenda with a repeater operation. Building on its experience in other countries in the region, IFC’s SME facility will also evaluate opportunities for indigenous business market access programs in an effort to facilitate inclusion initiatives in Mexico.

100. In summary, we propose under the Poverty and Inequality theme a r ich program o f analytic work to tackle poverty and inequality accompanied by two multisector policy-based operations, two SWAPS and one investment operation in the FY05-08 period.

Instruments to Increase Competitiveness

101. The competitiveness challenges being experienced by Mexico will l ikely increase due to the continued market expansion o f China and other competitors, the expiration o f preferential treatment in the agricultural sector under NAFTA and the decrease in U S tariffs with respect to other countries that compete with Mexico. The Bank, through the series o f Competitiveness and Trade Programmatic AAA (FY05-08), could play a role in helping to implement policy reforms to improve competitiveness an mitigate expected costs o f adjustment, in areas such as textiles and agriculture. In order to remain competitive, Mexico will have to accelerate i t s transition from a l ow value-added product export base economy to a higher value-added one. This will be key for Mexico to achieve robust economic growth in the coming years. The private sector has increasingly become aware o f this. The main focus

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o f IFC’s strategy in Mexico will be to support the country’s efforts to improve i t s competitiveness by assisting companies that seek to position themselves better vis-a-vis local, regional or global competitors. This support would be provided through investment and advisory assistance and could cover a wide spectrum, from SMEs to 2nd and top t ier companies as well as the public sector. On the latter, IFC stands ready to provide reimbursable advisory services to the authorities in coordination with, and complementing Bank’s work in this area.

102. I t involves policy interventions across sectors as wel l as sizeable investment (both public and private) in infrastructure and human capital. However, i t i s important to note that these should involve enhancing market efficiency rather than picking specific sectors to support. The Bank wil l start this work through the recently initiated Investment Climate Assessment (FY04) and a review o f the government’s Competitiveness Strategy. The Southern States Connectivity (FY05) study will analyze regional market disparities. Analytic work on Crop and Agro Competitiveness (FY06) will be carried out to complement the I C A with sector specific recommendations for agriculture.

103. The results o f this analytical work will help identify the relative priorities to improve competitiveness. We will assess those changes with short vs. long term benefits. This will allow us, in partnership with the government and the private sector, to propose an optimal policy agenda given Mexico’s constraints. A series o f policy-based loans in support o f policy reforms to improve competitiveness could result out o f this analytic work as wel l as more focused investment operations involving TA andor financing investment requirements. Further analytic work, which could include issues ranging from labor productivity to infrastructure, technology and innovation, will be carried out under the Competitiveness and Trade Programmatic AAA (FY05-FY08).

104. The Bank will support efforts to improve access to financial services on multiple fronts. We will continue to assist the government in i t s efforts to strengthen i t s development banks in order to improve their efficiency, reduce contingent liabilities, and focus their activities on developing financial markets. Recently completed analytical work on Access to Financial Services in Mexico City would provide the basis for a country wide study in FY06 and a lending operation in FY07. The Bank has also been asked to support the government’s work on Property Rights through an investment operation in FY06 to increase access to financial services and improve property tax administration. IFC’s current and potential work in the housing sector would also support the expansion o f the financial and capital markets through its activities in structured finance and mortgage securitization, among others. These lending efforts will be complemented by analytical work, including further study o f Capital Markets (FY07) and the next generation o f Pension Fund reforms (FY07) to be carried out in coordination between IFC and the Bank.

105. Bank support to infrastructure and services will focus on the government’s efforts to expand coverage, improve quality and reduce costs. The Highway Finance Loan (FY05) will help improve the design and financial engineering o f highway concessions. In order to ensure that the various infrastructure reforms permeate to sub-national governments, the Bank has responded to the government’s request for a Decentralized Infrastructure Development Loan to be approved in FY04, providing financing to States looking to strengthen their infrastructure strategy and planning and to develop their institutions. The success o f this loan

Improving competitiveness i s most urgent and challenging.

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will determine our possibilities for further lending in this area in FY08. Through a recently approved investment activity, IFC i s supporting interurban and semi-rural transport modernization and will seek to engage in opportunities with the private sector in the highway sector under a conducive regulatory framework. Also, based on the positive experience with the municipal finance project discussed in paragraph 67, IFC will seek new opportunities with the private sector in the area o f municipal infrastructure. IFC will also look to support new opportunities in the power sector where efficient and environmentally-friendly generation technologies are being adopted, as was the case wi th two FY03 operations. The Investment Climate Assessment i s expected to identify other areas where inadequate infrastructure limits Mexico’s productivity. Further studies and analytic work in such areas would be carried out under the overall heading o f Competitiveness and Trade Programmatic AAA. 106. Regarding the business environment, the f irst Knowledge and Innovation Project will lead to a repeater operation with CONACYT 11, as well as to the Life-Long Learning and Training SWAP program, both in FY05, envisioned to improve non-formal education, work force skills, innovation systems and ultimately product quality to respond to the demands o f a modernizing economy. WBI will include Mexico in a regional study on mobilization o f highly-skilled emigrants to support trade, investment and innovation. The Bank will support efforts to improve the quality o f primary and secondary education, as described in greater depth in the poverty theme above. A more difficult challenge i s in higher education, where strong resistance has deterred direct efforts to reorient highly regressive public spending. Ongoing pilots financed by the Bank to enhance access by the poor to both public and private higher education through granthtudent loan schemes have shown some promise and the Tertiary Education Financing II project in FY05 will support a scaled up operation. IFC’s involvement in the sector focuses in supporting expansion o f existing institutions as wel l as developing a financing facility for educational institutions.

107. Efforts to more fully integrate SMEs and the rural sector into the global economy focus on creating a market-friendly environment for their operations (e.g. , reducing the cost o f doing business, technology services, access to finance). These efforts will be supported through the Rural Savings & Credit II in FY04, the Access to Financial Services in FY07, and the E-Business II in FYO8. IFC expects to rapidly expand i t s SME facility and initiate technical assistance work in Mexico this calendar year focusing in one or more o f the following areas: (a) simplification o f business requirements; (b) access to markets and finance and other areas o f SME support. Through existing and potential new clients, IFC will seek to expand the use o f local SMEs either via linkage programs or through other viable means.

108. Moving forward on the theme o f business environments for productivity and competitiveness, IFC’s strategy will continue to focus on the following themes: (a) enhancing international competitiveness o f the private sector (including projects to promote more sophisticated technology and higher value-added products); (b) further deepening the financial sector with introduction and/or penetration o f specialized products and markets, such as housing, and more evenly distributed access to financing; (c) promoting investments in areas newly opened for private sector participation, such as infrastructure; and (d) promoting sustainable environmental and social development and good corporate governance. In implementing this strategy, IFC expects to place an increasing importance on the balance between the quality o f i t s portfolio and developmental reach through the following activities: (a) direct financing o f larger clients where IFC provides otherwise unavailable long-term

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financing and best practice expertise (for example, corporate governance and sustainability); (b) reaching smaller firms through financial intermediaries; and (c) targeted direct intervention with smaller projects in high impact areas (for example, micro finance), which have a high probability o f success.

109. In summary, for FY05-FY08 we propose in this theme a program o f analytic work around competitiveness and trade issues that could lead to policy-based programmatic operations, complemented by investment operations on innovation and technology, higher education and lifelong learning, infrastructure both at the federal and state levels, and access to financial services and property rights. IFC i s wel l positioned to provide support on sustainability issues, corporate governance, corporate strengthening through restructuring, and local supplier linkages. WBI will complement IFC support in the area o f corporate governance through capacity building services focusing on corporate social responsibility, as wel l as i t s importance, to ensure access to international markets and develop national competitiveness.

Instruments to Strengthen Institutions 1 10. With the deepening o f democracy and political decentralization, Mexico faces new institutional challenges for effective development. Cross-cutting to most o f the institution themes, the Bank started two tasks in FY03-04 that will have important follow-on activities supporting the government’s efforts to strengthen i t s institutions. SHCP contracted with the Bank on a fee-for-service basis to support the modernization o f processes within the secretariat. The Bank also responded to a request from the Budget Subsecretariat to do a Public Expenditure Review, the f irst ever at the national level in Mexico, focusing on issues o f flexibility o f spending, distribution o f spending benefits by household income level and by geographic area, and budget management institutions. This will be important for understanding the effects o f public spending today and for identifying where further study i s most needed on how to improve i t s efficiency and effectiveness in the future. The follow-on work will include expenditure studies in critical sectors identified by the PER, such as infrastructure, education and health. WBI, long active with subnational training programs, will participate in a multiyear set o f programs to support institutional strengthening in the Southern States. The final program will be defined in close collaboration with the C M U and the government.

11 1. To support transparency and accountability, programmatic analytical work with SHCP related to Federal Public Expenditures and Strengthening of Public Finances and Management at al l levels o f government are envisaged in the next three to four years. Through this AAA, Mexico could develop with the Bank a Strengthening Public Finances SAL, supported by a TAL in FY06. These operations would help simplify government services, train federal employees to the new budget and financial management systems, implement the new c iv i l service law, and reduce corruption. The Bank’s support for an integrated financial management mechanism will help Mexico achieve better macroeconomic forecasting, budgeting, and fiscal reporting, as wel l as better tax administration. This activity could also include support to IFAI-the new office for public information-as has been recently requested and will be complemented by an Institutional Governance Review in FY06. In addition, depending on the outcome o f the Convencibn Nacional Hacendaria in February- July 2004, the Bank could support SHCP’s efforts to strengthen subnational finances within the programmatic analytical work and lending on Public Finances and Management,

41

mentioned above, as well as with a State Pension Survey in FY07. To the growing demand for technical advisory services and seminars to congress (members, staff, and Contadurias Mayores) and local governments, the Bank will respond via WBI. The Institute has been active at the Federal and Subnational levels in providing distance learning programs for transparency and accountability for 240 Mexican Federal agencies and more than 200 municipalities, some on a cost recovery basis. The Bank will also conduct another round o f fiduciary assessments (CPAR and CFAA) in FY07-FY08 focusing in capacity enhancement and local capacity to complete the move towards national procurement and financial management systems during the period o f this CPS. It also expects to support Autonomous National University o f Mexico’s (UNAM) new anticorruption lab, and share knowledge from international experience on monitoring and evaluating government programs.

112. There are other opportunities to provide support to strengthen the capacity o f subnational governments (although developing lending will require a continued effort to more attractive lending terms to the States from the Mexican intermediary that borrows from the Bank). For example, the SFP has requested Bank assistance to identify the steps needed to allow for the use o f country systems and for the harmonization o f Financial Management and Procurement Standards (FY05) among the federal, state and municipal levels. The State- level Access to Justice TAL in FY04 will deal with a number o f States, and if successful, there could be a follow-on project to strengthen the State judiciaries (Access to Justice II) in FY07. The proposed Broadening Access to Justice AAA (FY05) and Streamlining Commercial Justice AAA (FYO6)would assist the government-the Comisidn Nacional de Tribunales in particular-to deal with issues complementary to the Access to Justice operations which are important to provide access to justice for the poor and to improve performance o f commercial courts. WBI’s Judicial Reform Learning Program will also include Mexico starting in 2004. Potential for linking learning to lending through this distance learning training will be explored. IFC could help SNGs to mobilize funds (such as the recent guarantee for the Tlalnepant l a water authority) . 113. For the professionalization o f the c iv i l service, the government i s wisely taking a gradual approach, starting with a focus on the accreditation and development o f mid- management positions within the Federal Government. The Bank will init ially provide support under capacity building initiatives, supported in part by WBI curricula and accreditation programs, and if requested by the government, could also support the integrity and capacity building efforts o f SFP within the Strengthening Public Finances lending and non-lending programmatic activities. For the reform o f ISSSTE, the Bank i s ready to provide support when the reform gets political approval, based on extensive analytic work over the past few years.

114. Finally, to continue with i t s efforts to disseminate knowledge and share international experiences, the Bank plans to update its 2000-01 Policy Notes in FY07. I t could once again become a useful advisory instrument during the next government transition.

115. In summary, under the Institutionality theme we propose a r ich program o f analytic work complemented by small investment operations in justice as wel l as a large policy-based operation and a TAL to strengthen public finances. Depending on the outcome o f the Convencidn Nacional Hacendaria in February-July 2004, there could also be large windows o f opportunity for Bank operations in this area.

42

Instruments to Promote Environmental Sustainability

116. Mexico’s increased attention to environment during the 1990s led to marked progress in some areas, most notably biodiversity and air pollution. To deepen these achievements, the government has expressed interest in the Bank’s support to integrate the principles o f sustainable development into country policies and programs and reverse the loss o f environmental resources. The Environmental SAL II operation in FY05 will promote the mainstreaming o f environmental concerns and improved local environmental management processes. Starting in FY05, the overall program o f Bank’s support under this theme will be underpinned by a Water Programmatic AAA, which will include studies on the economic value o f water, governance, public expenditure, environmental health and water quality management during the period o f this CPS.

117. Another important objective o f the work o f this theme i s to move to country based safeguards. A review o f Mexican Environmental and Social Standards (FY05) will be conducted to assess the gaps between Bank safeguard policies and those embodied in Mexican law and practices. This will allow us to trace a path and strengthen local capacity to move to Mexican safeguards within this CPS period. In FY07, the Environmental Management project will strengthen the federal agency for environmental management (PROFEPA) to enforce environmental legislation on industrial activities and natural resource management. PROFEPA officials will also participate in a pilot WBI learning program on environmental compliance measures and indicators. A Disaster Management study (FY06) will focus on risk reduction and r i s k transfer mechanisms. These tasks will be complemented and supported by WBI learning programs on indicators for environmental compliance and strategic environmental assessment. Building-up on i t s experience to date, IFC will continue promoting its sustainability agenda wi th existing and potential clients and working with them to increasingly adopt environmentally-friendly practices. Furthermore, IFC wil l stress the importance, from a business perspective, o f adopting sustainable practices, and the social benefits o f being a good corporate citizen.

118. Mexico’s efforts to address the nation’s water scarcity problem, high rates o f deforestation, and promote sustainable natural resources management to alleviate rural poverty include programs relating to water resource management and sustainable forest management. The IBRD/GEF-financed Water Resources Management II loan in FY05 will help improve conditions for sustainable integrated water resource management contribute to increased efficiency o f water use and fair water r ights allocations, and consolidate water management institutions and stakeholders participation in decision-making. The Water Rights loan in FY07 will seek to promote aquifer stabilization in water-stressed areas through retiring water concessions where demand for water exceeds sustainable supply via surface and groundwater sources. The Water Policy Development SAL proposed in FY07 will support the government’s efforts to increase quality o f services and financial and environmental sustainability through support for further legal, regulatory and institutional reforms. The Water and Sanitation Modernization and the Irrigation and Drainage Modernization 11 loans in FY08 will seek to implement these reforms in the delivery o f services. This work will build upon programmatic Bank analytical work and by a WBI-led program o f dialogues and learning programs leading up to the World Water Forum, to be held in Mexico in 2006. The Community Forestry III project in FY08 will assist indigenous communities and ejidos that own forests in priority areas to improve the management and conservation o f their forest

43

resources and to generate alternative sources o f income in a sustainable manner. The IBRD/GEF-financed Environmental Services (FY06) project will support the development o f economic incentives to promote conservation and sustainable forest management in priority watersheds. The GEF-financed Sustainable Land Management project (FY07) will support efforts to slow land degradation-including soil erosion and desertification-which affects nearly two-thirds o f Mexican soils. The GEF-financed Gulf of California (FY08) project will promote improved fisheries and coastal zone management.

119. To improve the environment, WBG activities will support on-going programs to address air pollution, solid waste management, promote clean energy technologies and reduce greenhouse gas emissions, and enforce national and State-level environmental management. The Bank, through the PCF and related carbon finance vehicles, has taken a leading role in the early implementation o f the Kyoto Protocol and can be an important partner in efforts to develop Mexico’s very large carbon trading market potential by new project development, capacity building and replication o f best practices. Climate change finance efforts in the Bank’s Mexico portfolio are centered on the PCF-financed: (a) ComexhidroLNELEC Hydro Umbrella (FY04) project which replaces fossil-fired electricity generation with a package o f mini-hydro developments associated with existing irrigation schemes; (b) Landfill Methane Umbrella (FY05) project that will capture landfill gas for power generation and thereby improve the sustainability o f waste management practices at multiple urban sites; (c) PEMEX Refinery Cogeneration (FY07) project that will use carbon finance to promote the use o f refinery wastes for high-efficiency production o f steam and power while the PCF-financed Bagasse Cogeneration (FY08) project will support a similar scheme with Mexican sugar factories; (d) Mexico Transport Corridors (FY07) project that will address the potential for carbon emissions reductions in the globally important transport sector, as well as; (e) the Netherlands Carbon Development Fund-financed Wind Umbrella (FY06) project that will support the displacement o f fossil energy through grid-connected windfarms; ( f ) the GEF- financed Large-scale Renewable Energy Development (FY05) project that will support the development o f grid-connected renewable energy resources as wel l as facilitate a financial mechanism offering competitively-based tariff support for wind, hydro, biomass, and other renewable technologies; and (g) the IBRD/GEF-financed Rural Electrzjkation (FY06) project that will promote the expansion o f electricity services to poor households in dispersed or remote areas, where connection to the electricity grid is not financially or logistically feasible. Building upon previous capacity building efforts in support o f the PCF program, WBI will work with the Secretaria de Medio Ambiente y Recursos Naturales (SEMARNAT) and the Secretaria de Energia (SENER) officials to examine opportunities for Mexico to participate in the emerging international carbon market.

120. In summary for FY05-FY07, under the theme o f environmental sustainability, we propose a substancial program o f analytical work. This AAA will be accompanied by two policy-based and six investment loans to support environmental and water sustainability issues (the possible use o f SWAPS will be explored). This program will be complemented by GEF and carbon financed vehicles.

IBRD’s Financial Instruments

121. The cooperation with the government would focus on the potential use o f existing IBRD financial products to manage i t s financial r isks per the government’s debt strategy. In particular, the use o f IBRD financial products to transform the net IBRD obligation into

44

Mexican Pesos could assist the States and local government to access IBRD funding and technical assistance through on-lending programs o f the Mexican development banks. IBRD would also work with the government to identify potential new products that could assist the government in i t s funding and risk management strategy.

122. The government o f Mexico has diversified the funding sources o f i t s program, tapping the financial markets efficiently. As can be seen from the graphs below, IBRD borrowing has allowed Mexico to diversify i t s sources o f funding contributing to lowering the cost and r i sk structure o f i t s overall funding program.

Figure 3. Emerging Markets, Mexico, and WB Spreads over US Treasury 1993-2003

l a EMBl Strip Spread (%)

EMBIPLUS-MX Strip Spread (%)

16 EMBI-MX Strip Spread (%)

14

12 - WB spread (%)

0 D

al g 10

s a i!

6

4

2

Year

123. Mexico was one o f the earlier countries to use the IBRD Fixed Spread Loan (FSL), taking advantage o f the embedded risk management tools. I t now seems wel l positioned to be among the f irst IBRD client countries to use the hll menu o f IBRD products to manage i t s financial risks. By signing a Master Derivatives Agreement (MDA) with IBRD, Mexico could enhance i t s capacity to manage the financial r isks in i t s debt portfolio by having access to a range o f IBRD hedging products, e.g., currency and interest rate swaps, caps and collars, and commodity swaps. In addition, Mexico could use the Deferred Drawdown Option (DDO) to manage the liquidity r i sk emanating from unexpected shocks, e.g., contagion effect, financial shocks, natural disasters, etc.

124. The Bank plans to work with the government to help structure an adequate portfolio o f IBRD financing from a cost and r isk perspective, taking into account the government’s existing asset and liability management framework, the available alternative sources o f finance, and the products and services the WB Treasury would be able to offer. Within the agreed upon lending envelope, IBRD loans, guarantees and hedging products could be applied at two levels (country and projects) and two dimensions (existing portfolio and new pipeline):

45

0 At the Country level, the financial products could be used to support Mexico’s debt and risk management strategy through: (a) traditional IBRD lending as needed; and (b) intermediation or guarantee o f long dated derivatives transactions to enable the government to better manage the financial risks, mainly the interest rate, currency and refinancing r isks. This would be achieved mainly through the use o f existing IBRD portfolio, and adequate structuring o f new financing within the overall government strategy. For example, the local currency products could be used to transform part o f the outstanding debt into local currency, hence reducing the vulnerability o f the government from currency exposure in their debt portfolio. In particular, NAFIN and BANOBRAS could benefit from IBRD’s financial products to better manage their exposure to currency and interest rate risks. Using Bank intermediation in funding and risk management operations could prove beneficial for the pricing o f loans o f the mexican development banks. In addition, the Federal government i s considering the use o f IBRD local currency product to develop an alternative to FOAEM to manage i t s currency exposure in this fund.

At the Proiect level, the government will be able to use the flexibility in the loan terms along with the hedging products and the Bank guarantees to reduce cost/risk structure of, and enhance projects. They could also use the flexibility o f IBRD loan guarantees and hedging products to structure more adequate financing for new projects. The flexible characteristics o f the loans would allow financing projects with longer loan maturities (up to 25 years, longer maturity than the standard is being demanded by the States for developmental projects). The IBRD borrowing by the States could effectively be transformed into Pesos at competitive pricing which would allow the States to stay engaged with the Bank for future development projects. IBRD financial products can also help to further tailor the financial terms for the final user in a way that will reduce their financial risks, e.g., local currency, fixed interest rate, and custom repayment schedule, while at the same time, help reduce r isks for the government intermediaries.

0

BUDGET TO IMPLEMENT THIS CPS 125. The budget required to implement the proposed CPS i s in line with the level o f funds provided for the Mexico program in recent years, as shown in the following table. The increase in FY05-06 in relation to FY04 represents a partial shift back o f resources to the Mexico program within LCClC’s total budget envelope (US$10.3 mi l l ion for FY05). The full implementation o f this CPS requires that Mexico’s, together with LCClC’s, WPA funding be maintained through FY08.

PRODUCT

LENDING

FY03 FY04 FY05 FY06 FY07 FYO8

1,851 1,363 1,410 1,453 1,249 1,300

SUPERVISION 1 AAA

I TOTAL I 6,383 5,469 I 5,940 5,995 5,981 6,000

2,747 2,257 1,867 1,969 1,908 2,000

1,785 1,849 2,663 2,573 2,824 2,700

46

R I S K S OF THE PROPOSED STRATEGY

126. The proposed strategy faces risks. First, as no single political party has a majority in Congress, i t may be difficult to implement pending reforms (fiscal, energy, pensions, labor, telecommunications, water, judicial, ete.). Arty one o f the three major political parties could win the next presidential election, however, so there may s t i l l exist window o f opportunity to build consensus to pass reforms with longer-term benefits.

127. Second, the recent incipient signs o f economic recovery in Mexico could be stalled if the U.S. economic upturn does not continue, i f there i s another emerging market crisis that spreads to Mexico, if Mexico i s unable to increase i t s competitiveness to respond to Asian competition in the North American market, or if there i s a significant downturn in o i l prices. This risk i s lessened by the government’s commitment to implement a program for enhancing trade competitiveness, and by Mexico’s recent solid macroeconomic and debt-management record (Le,, fiscal discipline and flexible exchange rate regime) that allowed i t to maintain access to capital markets during the recent international economic downturn and emerging market turbulence.

128. Third, structural problems in the State governments could result in a sub-national government entering into fiscal difficulties that could prevent it from delivering basic services or in excluded groups demanding improvements that could exceed the capacity o f local governments to respond. This r i sk i s especially acute in the poorer southern States. I t has been partly reduced by the establishment o f market-driven mechanisms for restraint o f sub- national debt and by the on-going efforts to strengthen the inter-government fiscal system.

129. Fourth, the non-additionality o f Bank financing from the point o f view o f l ine ministries presents a challenge to the Bank’s ability to develop the proposed lending program. This means that the Bank will need to ensure high value-added by working in areas where we can bring exceptional knowledge and the potential for impact. The strong proposed program o f analytical work in the CPS should help the Bank to achieve this goal.

130. Fifth, an overt strategy o f emphasizing AAA could backfire, jeopardizing the Bank’s reputation as a politically neutral advisor and actually reducing i t s fbture effectiveness. The Bank will have to make a strong effort to improve its AAA work quality and review processes (including increased participation o f government counterparts and local peer reviewers), while at the same strengthening its dissemination.

131. Finally, there i s an internal r i sk to the Bank. Under this strategy, if a few operations are dropped, the Bank’s lending could be significantly reduced. This r isk would be mitigated by the organization o f Bank staff in thematic clusters around Mexico’s main development challenges, and the continuous long-term engagement that these clusters would entail. This approach would focus the dialogue o f Bank management and government authorities on results and the delivery o f Bank activities to support these results.

CPS MONITORING 132. Overall implementation o f this CPS will be monitored on the basis o f the relative impact o f WBG’s support to help Mexico make progress in meeting its 2001-2006 National Development Plan basic objectives. The WBG intends to work in partnership wi th the government and other development partners to monitor progress based on the indicative country targets included in Annex A l . The Bank’s ongoing work and WBI’s learning

47

programs on monitoring and evaluation will provide the foundations for the implementation o f this effort.

V. CONCLUDING REMARKS

133. The objective o f this WBG partnership strategy i s to support Mexico’s efforts to reduce poverty and inequality, increase competitiveness, strengthen institutions and promote environmental sustainability. This strategy i s the result o f extensive analytical work, lessons o f operational experience, and country consultation.

James D. Wolfensohn President

By:

Shengman Zhang Peter L. Woicke

Washington, D.C., March 18, 2004

48

5

0 8 '

8 8

m M

c

i

CPS Annex B1- Mexico at a glance 9/3/03

2001 2002

4.1 4.0 27.1 26.6

18.9 19.6 68.7 69.4

69.6 70.0 11.8 11.8 29.7 29.2

POVERTY and SOCIAL

2002 Population, mid-year fmillioosJ GNI per capita (Atlas method, US$) GNI (Atlas method, US$ billions)

Average annual growth, 1996-02

Population (%) Labor force (%)

Most recent estimate (latest year available, 1996-02)

Poverty (% ofpopulation below national poverty line) Urban population (% oftotal population) Li fe expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition (%of children under 5) Access to an improved water source (% ofpopulation) llliteracy (% ofpopulation age lS+) Gross primary enrollment (% of school-age population)

Male Female

K E Y ECONOMIC RATIOS and LONG-TERM TRENDS

1982

Growth of investment and GDP (YO) 30

2o

10

-10

-GDI *GDP

GDP (US$ billions) Gross domestic investmentiGDP Exports of goods and servicesiGDP Gross domestic savingdGDP Gross national savings/GDP

Current account balance/GDP Interest paymentsiGDP Total debt/GDP Total debt service/exports Present value of debtiGDP Present value of debtiexports

3.3 -0.4 -3.5 0.0 -3.7 -0.6 0.7 1.4

2.7 1.2 -1.2 -1.3

173.7 22.9 15.3 27.9 21.5

-3.4 4.5

49.6 52.3

25

l5 2o

0 5

1982-92 1992-02 (average annual growth) GDP 1.9 3.2 GDP per capita -0.1 1.6 Exports of goods and services 5.1 13.4

-5.2 0.5 -1.5 1.6

Mexico

lQQ.9 5,920 597.0

1.4 2.4

75 74 25

8 88

8 113 1 I 4 1 I 3

1992

363.6 23.3 15.2 18.3 16.6

-6.7 1.6

30.9 33.8

2001

-0.3 -1.8 -3.6

ports -Imports

Latin America & Carib.

527 3,280 1,727

1.5 2.2

76 71 27

9 86 11

130 131 128

2001

623.9 20.9 27.4 18.6 17.9

-2.9 1.9

25.4 26.3

2002

0.9 -0.6 1.4

Upper- middle- income

321 5,040 1,668

1.2 1.8

75 73 19

90 7

105 106 105

2002

637.2 20.3 27.2 18.3 18.0

-2.2 1.7

24.2 18.8

2002-06

3.8 2.2 5.6

I Development diamond'

: Life expectancy

GNI

capita per

I

Access to improved water source

-Mexico ~ Upper-middle-income group

I Economic ratios'

Trade

T

indebtedness

-Mexico Upper-middle-income group

STRUCTURE of the ECONOMY

(% of GDP) Agiculture Industry

Manufacturing Services

Private consumption General govemment consumption Imports of goods and services

(average annual growfh) Adculture Industry

Manufacturing Services

Private consumption General govemment consumption Gross domestic investment Imports of goods and services

1982

8.1 33.4 21.7 58.4

61.6 10.5 10.3

1992

6.7 28.1 20.2 65.2

71.8 9.9

20.3

1982-92

0.7 2.5 3.0 2.0

2.7 2.1 2.5

11.2

1992-02

1.7 3.7 4.3 3.1

2.9 1.5 4.7

11.8

I 2o02 1 Growth of exports and imports (%) 2001

Note: 2002 data are preliminary estimates.

* The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete.

Annex B1 - 53

Mexico

PRICES and GOVERNMENT FINANCE

Domestic prices (%change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeficit

TRADE

(US$ millions) Total exports (fob)

O i l Agriculture Manufactures

Total imports (cif) Consumer goods Intermediate goods Capital goods

Export price index (1995=100) Importprice index (1995=100) Terms o f trade (1995=100)

BALANCE of PAYMENTS

(US$ millions) Exports o f goods and services Imports o f goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, localRJS$)

EXTERNAL. DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed

IBRD I D A

Total debt service IBRD IDA

Composition o f net resource flows Official grants Official creditors Private creditors Foreign direct investment Portfolio equity

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

1982

58.9 60.9

27.4 -6.0

-14.1

1982

24,055 16,477

1,233 5,843

17,011 1,517

10,991 4,502

127 74

171

1982

28,169 22,841

5,328

-12,261 1,043

-5,890

2,316 3,574

914 5.64E-2

1982

86,08 1 2,692

0

15,684 328

0

76 1,577 6,391 1,655

0

540 408 133 275 195 80

1992

15.5 14.4

23.7 5.0 1.4

1992

46,196 8,307 2,112

35,420 62,129

7,744 42,830 11,556

91 91

100

1992

55,387 73,617

-18,230

-9,595 3,386

-24,438

26,184 -1,745

18,975 3.1

1992

112,315 11,966

0

20,75 1 1,874

0

14 615

-53 1 4,393 4,783

1,313 1,352

981 371 892

-522

2001

6.4 6.5

21.8 1.9

-0.7

2001

158,443 12,799 3,903

141,353 168,396

19,752 126,149 22,496

103 103 101

2001

171,103 184,614 -13,511

-13,835 9,338

-18,008

25,347 -7,339

44,814 9.3

2001

158,291 10,883

0

48,729 2,178

0

-669 3,198

25,334 151

860 749

1,314 -565 864

- 1,429

2002

5.0 4.6

22.6 0.2

-1.2

2002

160,813 14,475 3,998

14 1,95 1 168,949 21,178

126,778 20,992

106 104 102

2002

173,374 185,419 -12,045

-12,282 10,268

-14,058

19,851 -7,375

50,607 9.7

2002

153,923 10,596

0

35,254 2,093

0

-432 -3,932 13,627

-104

1,322 1,247 1,356 -108 737

-845

97 98 99 00 01

-GDP deflator *CPI

Export and import levels (US$ mill.)

200.000 T

96 97 98 99 00 01 02

Exports Imports

I Current account balance to GDP (%)

I -51

1 Composition of 2002 debt (US$ mill.)

F: 116503

A - IBRD B - IDA D - Other multilateral F - Private C - IMF

E - Bilateral

G - Short-term

Development Economics 913103

Annex B1 - 54

C P S Annex B2 - Mexico Selected Indicators* o f Bank Portfolio Performance and Management

As of February 29,2004

Indicator 2001 2002 2003 2004 Portfotio Assessmen€ Number o f Projects Under Implementation a 28 28 26 24 Average Implementation Period (years) 3.1 3.1 3.4 3.0 Percent o f Problem Projects by Number 10.7 3.6 11.5 12.5 Percent o f Problem Projects by Amount as 12.6 8.1 22.6 20.8 Percent o f Projects at Risk by Number a, 10.7 3.6 11.5 12.5 Percent o f Projects at Risk by Amount 12.6 8.1 22.6 20.8 Disbursement Ratio (%) e 25.7 14.7 25.5 12.5 Portfolio Management CPPR during the year (yedno) No No Yes Planned Supervision Resources (total BB in US$OOO) 2,144.5 2,006.0 2,625.0 2,429.0 Average Supervision (US$OOO/project) I 76.6 71.6 101.0 101.2

Memorandum Item Since FY 80 Last Five FYs Proj Eval by OED by Number 129 18 Proj Eval by OED by Amt (US$ millions) 24,8 1 1.3 5,100.5 % of OED Projects Rated U or HU by Number 27.6 17.6 % o f OED Projects Rated U or HU by Amt 17.7 4.6

a. As shown in the Annual Report on Portfolio Perfonnance (except for current FY). b. Average age of projects in the Bank's country portfolio. c. Percent o f projects rated U or HU on development objectives (DO) andor implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio o f disbursements during the year to the undisbursed balance o f the Bank's portfolio at the

f. Current FY figures are estimates. * All indicators are for projects active in the Portfolio, with the exception o f Disbursement Ratio,

beginning o f the year: Investment projects only.

which includes all active projects as well as projects which exited during the fiscal year.

Annex B2 - 55

CPS Annex B3 - Mexico IBRD Program Summary

Proposed IBRD Lending Program As o f February 29,2004

Strategic Implementa Rewards t Z R i s k s h j * F&l

year

2004

2005

2006

2007

2008

E-Business for Small Enterprises (Approved on 7/3 1/03) 58.4 M L Community Forestry I1 (Approved on 12/9/03) 21.3 M L Irrigation & Drainage Modernization (Approved on 12/9/03) 303.0 M L _ _ Basic Education Development APL 111 Housing & Urban Program SAL I + TAL Decentralized Infrastructure Development I Rural Savings & Credit I1 Access to Justice I

Result

Tertiary Education Financing I1 Conacyt I1 Lifelong Leaming & Training SWAP Highway Finance SAL Environmental SAL I1 Water Resources Management I1

Result

Contigo SAL Education Quality SWAP Access to Land for Young Farmers Housing & Urban Program SAL I1 Strengthening Public Finances (SAL + TAL) Property Rights Program

Result

Health System (Seguro Popular) SWAP Access to Financial Services Water Policy Development SAL + TAL Access to Justice I1 Water Rights Environmental Management

Result

Decentralized Infrastructure Development I1 Housing & Urban Program SAL 111 E-Business I1 Water & Sanitation Modernization Irrigation & Drainage Modernization I1 Community Forestry 111

Result

Overall Result Of which Quick-disbursing is

FY 2005-2008 Result Of which Quick-disbursing is

200.0 130.0 130.0 50.0 20.0

912.7

200.0 200.0 200.0 300.0 200.0 100.0

1,200.0

300.0 300.0 100.0 100.0 300.0 100.0

1,200.0

300.0 300.0 350.0 50.0

100.0 100.0

1,200.0

250.0 200.0 100.0 300.0 300.0

50.0

1,200.0

5,712.7 1,750.0 31%

4,800.0 1,650.0 34%

M M H M H

M M M H M M

H M M H H M

M M M H M M

H H M H M M

L M M M M

L L M M L L

M L L H M L

M M L L M L

L H L M L L

Annex B3 - 56

CPS Annex B3 (IFC & MIGA) - Mexico IFC Program, N 2001-2004

as of January 31,2004 2001 2002 2003 2004

~ ~~~~

I FC approvals (US$m)

Sector (YO) Agriculture & Forestry Accomodation & Tourism Chemicals Collective Inv Vehicle Finance & Insurance Health Care Industrial & Cons Prod Information Oil, Gas & Mining Pulp & Paper Transportation & Warehousing Utilities Wholesale & Retail Trade Total

Investment instrument (YO) Loans Equity Quasi-Equity Other Total

MIGA Guarantees (US$m)

245.38

3

4 0

88

1

5

101

90 5 5 0

100

0.00

54.00 329.50

12

9 24 11

8

0 36

45

100 101 56

89 65 5 3 6 27 0 4

100 99

0.00 0.00

83.00

19

27

54

100

98 0 0 2

100

0.00

Annex B3 - 57

CPS Annex B3 - Mexico Proposed IBRD/GEF/PCF Program Summary

As o f February 29,2004

US$(M) US$(M) US$(M) ~ IBRD GEF PCF ~ FY -Praj ~~

2004

2005

2006

2007

2008

INELEC Hydro Umbrella

Large-scale Renewable Energy Development Landf i l l Methane Umbrella

Rural Electrification Environmental Services Wind Umbrella

Mexico Transport Corridors PEMEX Refinery Cogeneration Sustainable Land Management

Bagasse Cogeneration Gulf o f California

25.0

7.5

20.0

15.0 5.0 40.0 10.0

10.0

10.0 10.0

10.0

5.0 20.0

Overall Result 55.0 70.0 62.5

Annex B 3 - 58

CPS Annex B4 - Mexico Summary of Nonlending Services FYOS-OS

As o f February 29,2004

FY Product Cost (us$oOO) Audience Objective

2005 Poverty

Competitiveness

Institutionality

Env. Sustainability

2006 Poverty

Competitiveness

Institutionality

Env. Sustainability

2007-08 Poverty

Competitiveness

Institutionality

Env. Sustainability

Poverty Programmatic I1 a) Health Policy & Nutrition

~ b) Monitoring & Evaluation c) Core Diagnostic I1 d) Labor Markets e) Social Protection I1 f) Health Services Delivery I

Quality of Education Programmatic I Land Reform Competitiveness & Trade Programmatic I

Public Finances and Management Programmatic I

Sectoral Public Expenditure Review I Broadening Access to Justice DisseminatiodOutreac h Water Programmatic I

Environmental & Social Standards Review

Poverty Programmatic 111

a) Southern States Connectivity

a) FM+PR Country Systems Review

a) Economic Value of Water

a) Poverty & Decentralization b) Monitoring & Evaluation I1 c) Health Services Delivery I1

Quality of Education Programmatic I1 Competitiveness & Trade Programmatic I1

a) Crops & Agro Competitiveness b) Access to Financial Services

a) Institutional Governance Review b) Country Economic Memorandum

Sectoral Public Expenditure Review I1 Streamlining Commercial Justice Disseminatiodoutreach Water Programmatic I1

a) Governance + Publ.Exp.Assess. Economic Instruments for Environmental Mgmt Disaster Management (Risk + Insurance)

Poverty Programmatic I V

Public Finances and Management Programmatic I1

a) FY04-06 Summary Report b) Health Service Delivery 111

Quality of Education Programmatic 111 I M S S Study Rural Decentralization Competitiveness & Trade Programmatic 111

2nd. Generation Pension Reform Public Finances and Management Programmatic 111

a) State Pension Survey b) Country Financial Accountability Assessment c) Country Procurment Assesment Report

a) Capital Markets Development

Policy Notes Country Assistance Strategy Disseminatiodoutreach Water Programmatic 111

a) Environm Health + Water b) Water Quality Management

171 88 88 88 88 88 88 171 88 171 88 171 88 88 88 88 171 88 88

171 88 88 88 171 171 88 88 171 88 88 88 88 88 171 88 88 88

171 88 88 171 88 88 171 88 88 171 88 88 88

238 238 88 171 88 88

~~ ~

G, B, PD G, B, PD G, B, PD GB, PD G, B, PD G, B, PD G, B, PD G, B, PD

G, B G, B, PD

G, B G, B, PD

G, B G, B, PD G, B, PD

PD G, B G, B G, B

G, B, PD G, B, PD G, B, PD G, B, PD G, B, PD G, B, PD

G, B G, B

G, B, PD G, B G, B

G, B, PD G, B, PD

PD G, B

G, B, PD G, B G, B

G, B, PD

G, B G, B, PD

G, B G, B

G, B, PD G, B G, B

G, B, PD G, B G, B G, B G, B G, B PD

G, B, PD G, B, PD G, B, PD

KG, PD KG, PD KG, PD KG, PD KG, PD KG, PD KG, PD KG, PD KG, PS KG, PD

KG KG, PD KG, PS KG, PD KG, PD

PD KG KG

KG, PS

KG, PD KG, PD KG, PD KG, PD KG, PD KG, PD

KG KG, PS KG, PD

KG KG

KG, PD KG, PD

PD KG

KG, PD KG KG

KG, PD

KG KG, PD

KG KG

KG, PD KG KG

KG, PD KG, PS

KG KG KG KG PD

KG, PD KG, PD KG, PD

(a) G = Government; B = Bank; PD = Public dissemination (b) KG = Knowledge generation; PD = Public debate; PS = Problem solving

Annex B4 - 59

CPS Annex B5 - Mexico Mexico Social Indicators

~ ~~~~~ ~~~ ~~ ~~ ~~~ ~

POPULATION Total population, mid-year (millions)

Urban population (% of population) Total fertility rate (births per woman)

POVERTY (% ofpopulation) National headcount index

Urban headcount index Rural headcount index

Growth rate (% annual average for period)

INCOME GNI per capita (US$) Consumer price index (1995=100) Food price index (1995=100)

INCOME/CONSUMPTION DISTRIBUTION Gini index Lowest quintile (% of income or consumption) Highest quintile (% of income or consumption)

SOCIAL INDICATORS Public expenditure

Health (% of GDP) Education (% of GDP) Social security and welfare (% of GDP)

Net primary school enrollment rate (% of age group)

Total Male Female

Access to an improved water source (% ofpopulation)

Urban Rural

Total

Immunization rate (% under 12 months)

Measles DPT

Child malnutrition (% under 5 years) L i f e expectancy at birth (years)

Total Male Female

Mortality Infant (per 1,000 live births) Under 5 (per 1,000 live births)

Male (per 1,000 population) Female (per 1,000 population)

Births attended by skilled health staff (%)

Adult (15-59)

Maternal (modeled, per 100,000 live births)

Latest single year

1970-75

59.1 3.1

62.8 5.8

1,480 0

3.7 3.6

83 83 82

17

64 61 67

68 92

246 188

~~~~

1980-85

75.5 2.2

69.6 3.9

2,180 3 4

3.7 2.2

100

64 40

69 66 72

47 60

216 135

1995-261

99.4 1.4

74.6 2.5

45.7 36.3 73.3

5,530 255 254

51.9 3.4

57.6

2.5 4.4 3.3

103 103 104

88 95 69

97 97

8

73 70 76

24 29

180 101 65 86

Same regionhcome group

Latin & America Carib.

523.6 1.5

75.8 2.5

3,580

3.3 4.4

97 98 96

86 94 65

91 89 9

71 67 74

28 34

22 1 124

Upper- middle- income

503.6 1.3

77.2 2.3

4,550

3.5 4.4

96 97 95

88 94 69

94 94 9

72 68 75

23 27

218 114

Note: 0 or 0.0 means zero or less than halfthe unit shown. Net enrollment rate: break in series between 1997 and 1998 due to change from ISCED76 to ISCED97; ratios exceeding 100 indicate discrepancies between the estimates of school-age population and reported enrollment data.

2003 World Development Indicators CD-ROM, World Bank

Annex B5 - 60

CPS Annex B6 - Mexico Key Economic Indicators

(Calendar Years)

Indicator 1999 2000 2001 2002 2003 2004 2005 2006

National accounts (as YO GDP at current market prices)

Gross Domestic Product Agriculturea Industrya Servicesa

Total Consumption Gross Domestic Investment

Government Investment Private Investment (includes increase in stocks)

Exports (GNFS)b 1mp0rts (GNFS)~

Gross Domestic Savings Gross National Savings'

Memorandum items

100.0 100.0 4.7 4.2

28.7 28.0 66.6 67.8

78.1 78.1 23.4 23.7 3.0 3.6

20.4 20.1

30.8 31.0 32.4 32.9

21.9 21.9 20.6 20.5

100.0 100.0 4.2 4.0

27.3 26.5 68.6 69.5

Gross Domestic Product 481,094 581,326 62 (US$ mi l l ion at current prices)

81.6 80.3 20.9 19.9

3.2 3.3 17.7 16.7

27.5 26.7 29.8 28.7

18.4 19.7 17.7 19.4

100.0 4.0

26.4 69.6

77.9 19.3 2.3

18.0

28.3 29.7

22.1 22.3

,270 648,458 625,535 61

100.0 3.7

23.6 65.5

81.8 20.3 0.9

19.4

30.1 32.2

18.2 22.6

100.0 100.0 3.7 3.7

23.7 23.7 65.0 64.7

82.3 82.1 20.4 21.1

1.0 1 .o 19.4 20.1

29.9 30.1 32.6 33.3

17.7 17.9 21.6 21.6

,702 645,383 681,118

Gross National Product per 4,440 5,090 5,540 5,910 5,990 5,750 5,980 6,230 Capita (US$, Atlas method)

Real Annual Growth Rates (%, calculated f rom 1993 prices)

GDP at market prices 3.7 6.6 -0.1 0.7 1.3 Gross Domestic Income 4.6 7.7 0.0 1.1 1.8

3.1 3.8 4.0 2.4 3.5 3.9

Real Annual per Capita Growth Rates (%, calculated from 1993 prices)

GDP at market prices 2.3 5.0 -1.6 -0.8 -0.1 1.7 2.4 2.6 Total Consumption 2.9 5.9 0.7 -0.6 0.1 1.5 2.7 2.1 Private Consumption 2.9 6.7 1.2 -0.3 -0.3 1.9 2.9 2.2

(Continued)

Annex B6 - 61

CPS Annex B6 - Mexico K e y Economic Indicators (continued)

(Calendar Years)

__ Actaaf n fi-F Indicator 1999 2000 2001 2002 2003 2004 2005 2006

Balance of Payments (US$ m)

Exports (GNFS)D

Imports (GNFS)D

Resource balance Net current transfers (including official current transfers) Current account balance (after official capital grants)

Merchandise FOB

Merchandise FOB

Net private foreign direct investment Portfolio investment Long-term loans (net)

Official Private

Other capital (net, including errors and omissions) Net use o f IMF resources Change in gross reserves

Memorandum items Resource balance (% o f GDP at current market prices) Current account balance (% o f GDP at current market prices)

Annual growth rates (%) Merchandise exports Merchandise imports

148,083 136,391 155,465 141,975

80,167 66,455 90,494 74,458

71,103 173,454 58,443 160,763 84,614 185,419 68,396 168,679

6,313 6,994 9,338 10,268 -7,382 -10,326 -13,511 -11,964

-14,001 -18,167 -18,158 -14,053

13,166 16,449 26,569 14,435 3,769 447 151 -104

12,793 -6,996 1,175 -4,012 -1,670 -526 -669 246 14,462 -6,470 1,844 -4,258 -7,767 19,717 -2,399 11,108

-3,682 -4,299 0 0 -4,278 -7,150 -7,339 -7,375

-1.5 -1.8 -2.2 -1.8

-2.9 -3.1 -2.9 -2.2

16.1 22.0 -4.8 1.5 13.2 22.9 -3.5 0.3

178,014 165,355 188,083 170,958

13,727 -10,070

-9,150

10,73 1 -123 -790 -372 -418

1,230

0 -1,898

-1.6

-1.5

2.8 1.2

184,330 192,977 170,147 177,872 197,522 2 10,623 179,643 191,620

13,999 15,403 -13,191 -17,646

-14,967 -18,065

13,888 15,276 1,146 1,204 1,396 3,233 -1 82 -3 5

1,578 3,268 0 2

0 0 -1,463 -1,650

-2.2 -2.7

-2.4 -2.8

2.9 4.5 5.1 6.7

205,214 189,128 2 2 7,O 5 4 206,8 16

16,947 -2 1,840

-2 1,504

16,040 1,264 6,419 -198

6,6 17 0

0 -2,220

-3.2

-2.7

6.3 7.9

(Continued)

Annex B6 - 62

CPS Annex B6 - Mexico Key Economic Indicators (continued)

(Calendar Years)

Indicator 1999 2000 2001 2002 2003 2004 2005 2006

Public finance (as % of GDP at current market prices)a

Current revenues Current expenditures Current account surplus (+) or deficit (-) Capital expenditure Overall Balance

Monetary Indicators M2/GDP (at current market prices) Growth o f M2 ("h) Private sector credit growth/ total credit growth (%)

Price indices (1993=100) Merchandise export price index Merchandise import price index Merchandise terms o f trade index Real exchange rate (LCU/US$)e

Consumer price index ("h growth rate, period average) Consumer price index (% growth rate, end o f period) GDP deflator (% growth o f rate)

20.8 19.2 1.5

2.7 -1.1

26.1 14.2

112.1 107.5 104.2 105.8

16.6

12.3

15.2

21.6 20.1

1.5

2.7 -1.1

20.6 -5.7

120.6 110.6 109.0 93.8

9.5

9.0

12.1

21.9 20.0

1.9

2.6 -0.7

22.2 14.1

117.9 111.3 106.0 85.6

6.4

4.4

5.9

22.2 20.2 2.0

3.2 -1.2

21.6 4.6

120.7 110.8 108.9 83.3

5 .O

5.7

6.9

23.7 21.3 2.3

3.0 -0.7

126.7 113.5 111.7 91.1

4.5

4.0

6.5

23.3 20.7 2.6

3.0 -0.3

126.7 115.9 109.3 94.0

3.7

3.0

3 .O

23.1 20.3 2.7

2.9 -0.2

128.4 118.6 108.2 94.9

3.4

3 .O

3.0

23.0 20.1 2.9

2.9 0.0

130.8 121.5 107.7 95.7

3.2

3 .O

3.0

a. b.

d. e.

C.

GDP components estimated at factor cost, as a % o f GDP at factor cost. "GNFS" denotes "goods and nonfactor services". Includes net unrequited transfers excluding official capital. Consolidated non-financial public sector "LCU" denotes "local currency units". A decrease in LCU/US$ denotes appreciation.

Annex B6 - 63

CPS Annex B7 - Mexico K e y Exposure Indicators

(Calendar Years)

- Actual d Projected Indicator 1999 2000 2001 2002 2003 2004 2005 2006

Total debt outstanding and disbursed (TDO) (US$m)a

Net disbursements (US$m)a

Total debt service (TDS) (uS$m)a

Debt and debt service indicators (%>

TDOKGS'

TDSIXGS~ TDO/GDP

IBRD exposure indicators (%) IBRD DS/public DS Preferred creditor/ public DS (%)' IBRD DS/XGSD IBRD TDO (US$m)a

Present value of guarantees (US$m)

Share of IBRD portfolio (%)

IFC (US$m) Loans Equity and quasi-equitye

166,463

9,111

35,310

108.1 34.6 22.9

10.1 39.0

1.4 11,353

326

9.3

402 57

150,313

-1 1,295

58,809

80.5 25.9 31.5

7.4 29.1

1.2 1 1,444

0

9.4

424 75

145,675

1,175

48,290

80.9 23.4 26.8

8.8 11.7

1.2 10,883

0

8.9

141,264

-4,012

43,535

77.1 21.8 23.8

10.9 15.0

1.1 10,797

0

8.8

140,39 1

-790

34,279

73.4 22.4 17.9

13.8 20.7

1 .o 10,717

0

9.3

140,778

1,396

33,568

71.0 23.0 16.9

13.1 19.9

0.9 10,555

0

9.2

...

...

144,O 13

3,233

30,720

69.1 22.3 14.7

13.0 20.9

0.9 10,380

0

9.2

...

...

150,430

6,4 19

36,123

67.7 22.1 16.3

13.4 22.0

0.8 9,75 1

0

8.6

...

...

MIGA guarantees (US$m)

a. b. c.

d. e.

Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short-term capital. "XGS" denotes exports o f goods and services, including workers' remittances. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank o f International Settlements. Includes present value o f guarantees. Includes equity and quasi-equity types of both loan and equity instruments.

Annex B7 - 64

d B

w

CPS Annex BS (IFC) - Mexico Statement of IFC's H e l d and Disbursed Portfolio

As of Dec 31,2003 (In U S Dollars Millions)

1988119911199211993/1 1998 2001 199511999 1998 1998 199412001 2000 1997 2001 2003 2002 1999 2001 2000 199712001 1998 200 1 199111996 199612000 200112002 1998 1989 1997 1992119931199511996/1 1998 2000 2000 2000 2004 200012001 2003 1998 2003 199511999 1996/1999/200012001 2003 2004 2003 2000 2001 2002 2002 2000 2000 2000 2001 1997 1992 2003 2002 1998

Total Portfolio:

Auasco Avvi BBVA-Bancomer Baring MexFnd CIMA Mexico CIMA Puebla CTAF'V Chiauas-Proualma Comercializadora Comuartamos Couamex Copuel Corsa Ecomex Educacion Fondo Chiauas Foria Monterrev GFNorte GIBSA GIRSA Gruuo BBVA Grupo Calidra Gruuo FEMSA Gruuo Minsa GNUO Posadas Gruuo Sanfandila Hospital ABC ITR Innouack Interoval InverCau Lomas de Real Merida III Mexmal Mexulus Puertos NEMAK Occidental Mex Occihol POLOMEX S.A. Pan American Plata Puertas Finas Oualita Rio Bravo Saltillo S.A. Servicios Su Casita TMA Toluca Toll Road Valle Hermoso ZN Mexico Il ZN Mxc Eqty Fund

7.20 6.43

37.65 0.00 0.00 6.75 1.54 0.00 1.53 1.00

50.00 30.00 8.36 5.00 6.50 0.00 8.36

50.00 13.52 41.57 0.00 8.00 0.00

12.60 28.81 5.72

30.00 11.00 0.00 0.00 0.00

50.00 27.56 0.00 0.00 0.00

30.00 0.00 8.00 0.00 9.50

13.00 0.00

47.12 33.16 9.00 0.00 1.86 0.32

50.00 0.00 0.00

651.06

0.00 0.00 0.00 8.40 4.80 0.00 0.00 1.02 0.00 0.66 0.00 0.00 3.00 0.00 0.00 3.53 3.00 0.00 0.00 0.00

32.67 6.00 2.85 0.00 5.00 0.00 0.00 0.00

15.00 0.01 1.07 0.00 0.00 0.00 4.46 0.00 0.00 9.99 0.00 5.88 0.00 0.00 2.50 0.00 0.00 1.90

10.62 0.00 0.00 0.00

10.00 15.30

147.65

0.00 0.00 0.00 0.00 0.00 0.00 0.84 0.00 1.09 0.00

25.00 0.00 0.00 1.50 0.00 0.00 0.00 0.00 0.00 3.57 0.00 0.00 0.00 0.00

15.00 0.00 0.00 0.00 0.00 0.00 0.00

20.00 0.00

10.00 0.00 9.04 0.00 0.00 0.00 0.00 0.00 0.00 3.50 0.00 0.00 0.00 1.66 2.82 0.00

20.00 0.00 0.00

114.03

28.80 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1.88 0.00 0.00 0.00 0.00 0.00 0.00 0.00 8.36 0.00

45.48 51.43 0.00 5.00 0.00

17.97 0.00 2.21

14.00 3.00 0.00 0.00 0.00

83.46 63.84 0.00 0.00 0.00

40.00 0.00 0.00 0.00 0.00 0.00 0.00

54.1 1 39.12

8.33 0.00 6.47 0.00

83.92 0.00 0.00

557.38

7.20 6.43

37.65 0.00 0.00 3.25 1.54 0.00 1.53 1.00 0.00

30.00 8.36 3.00 4.90 0.00 8.36 0.00

13.52 41.57 0.00 8.00 0.00

12.60 28.81

5.72 10.29 11.00 0.00 0.00 0.00 0.00

27.56 0.00 0.00 0.00

30.00 0.00 8.00 0.00 9.50

13.00 0.00

47.12 33.16 9.00 0.00 1.86 0.32 0.00 0.00 0.00

424.25

0.00 0.00 0.00 8.39 4.80 0.00 0.00 0.89 0.00 0.66 0.00 0.00 3.00 0.00 0.00 0.1 1 3.00 0.00 0.00 0.00

32.67 6.00 2.85 0.00 5.00 0.00 0.00 0.00

15.00 0.01 1.06 0.00 0.00 0.00 4.46 0.00 0.00 9.99 0.00 5.88 0.00 0.00 2.50 0.00 0.00 1.90

10.62 0.00 0.00 0.00 4.47

15.30

138.55

0.00 0.00 0.00 0.00 0.00 0.00 0.84 0.00 1.09 0.00 0.00 0.00 0.00 1.50 0.00 0.00 0.00 0.00 0.00 3.57 0.00 0.00 0.00 0.00

15.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

10.00 0.00 9.03 0.00 0.00 0.00 0.00 0.00 0.00 3.50 0.00 0.00 0.00 1.66 2.82 0.00 0.00 0.00 0.00

49.02

28.80 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1.88 0.00 0.00 0.00 0.00 0.00 0.00 0.00 8.36 0.00

45.48 5 1.43 0.00 5.00 0.00

17.97 0.00 2.21 7.21 3.00 0.00 0.00 0.00 0.00

63.84 0.00 0.00 0.00

40.00 0.00 0.00 0.00 0.00 0.00 0.00

54.11 39.12

8.33 0.00 6.47 0.00 0.00 0.00 0.00

383.20

Annex B8 - 66

b W

I

G

4

I m

E

W W

4

s

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P

v,

E - E .- I

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b .- * a 8 9

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v CI

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p' I-

0 0 R t:

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p'

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4