A WORLD BANK COUNTRY STUDY PUB- 1671

MEXICOManufacturing Sector: Situation, Prospects andPolicies

FILE COPY

MARCH 1979

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

MEXICOManufacturing Sector: Situation, Prospects and Policies

This report is based on the findings of a mission which visited Mexico in October/Novem-ber 1976. The mission was composed of:

A. Nowicki, chiefJ. Bergsman, deputy chiefD. Keesing, export analysis

T. Hutcheson, finance; import controlsD. Cook, small and medium-scale industry

J. Levitsky, small and medium-scale industryF. de la Balze, small and medium-scale industry

J. Kendall, public sector enterprisesH. Choi, capital goods sector

S. Swayambu, capital goods sector.W. Oettinger, capital goods sector

D. Weigel, private bankingA. Tejano, statistical assistance

Latin America and Caribbean RegionThe World Bank

Washington, D.C., U.S.A.

The World Bank issues country economic studies in two series. This report is a workingdocument and is, as such, part of an informal series based wholly on materials originallyprepared for restricted use within the Bank. The text is not meant to be definitive, but isoffered so as to make some results of internal research widely available to scholars andpractitioners throughout the world. A second, more formal series entitled World BankCountry Economic Reports is published for the Bank by The Johns Hopkins UniversityPress, Baltimore and London. Titles of these and all other Bank publications may befound in the Catalog of Publications, which is available free of charge from World Bank,Publications Unit, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A.

This report is a free publication. A small charge may be made if airmail postage isrequired.

The views and interpretations in this report are the authors' and should not be attributedto the World Bank, to its affiliated organizations, or to any individual acting on theirbehalf.

Copyright '() 1979 The International Bank for Reconstructionand Development/The World Bank

The World Bank enjoys copyright under Protocol 2 of the Universal Copyright Conven-tion. Nevertheless, reproduction of any part of this report is hereby granted providedthat full citation is made.

Preface

This report is based on the findings of a World Bank mission thatvisited Mexico in Oetober and November of 1976. The report was completedby May 1977. Immediately before and since then rapid and profound changesin economi.: conditions and policies in Mexico have occurred.

On September 1, 1976, one month before the mission visited Mexico,the exchange rate which had been in force since 1954 was abandoned.Incentives to manufactured exports were discontinued; indeed for a few weeksa tax was imposed on manufactured exports. A new Government was installedshortly afterwards. It rapidly designed and instituted administrative reforms,made adjustments in a number of policies which are discussed in the presentreport, and put other policies under review.

Because of those relatively recent changes and ongoing reviews, itwas not possible for the mission to evaluate (or even fully describe) Mexico'semerging policy framework. It was clear, however, that many of those changeswere in the directions suggested by the mission's (as yet unfinished)analysis. Now, some two years later, many more positive steps have beentaken to improve the situation analysed in the report. The grave economicsituation of 1976 has been resolved; investors' confidence returned, equilibriaon the external and fiscal account are in the process of being restored, andafter a two-year recession the Mexican econonW has begun to grow rapidly again.In the manufacturing sector, the high bias against exports that prevailed in1976 has been reduced by the reinstatement of the tax reimbursement program("CEDIs"). Import liberalization is steadily progressing and over 5,000 outof the 7,455 tariff categories can be now imported without an import license.Free import categories comprise about one-third of the value of all imports,but when imports by government agencies of certain products with only nominalimport control are added, over one-half of value of all imports enter free ofany non-tariff restrictions.

Efforts to cut costs and deficits in public sector enterprises,especially the Federal Electricity Commission, are underway. Various capitalmarket reforms have helped to provide an adequate credit supply, and specialfunds for small and medium-scale firms and for exporters are in fulloperation. There is more flexibility in dealing with proposals for newforeign private investment, whenever they meet Mexico's developmentpriorities. Pub'lic sector agencies are no longer permitted imports ofcapital goods on an import duty-free basis. Important measures to promotedevelopment of capital goods production are now being designed.

The geographic incentives to develop certain regions have beengreatly improved; the new scheme concentrates on four special ports andeleven regions with good growth potential. Investment incentives are lessbiased towards capital-intensive production processes than they were in therecent past, and special tax certificates related to the size of the wagebill are now being considered to tilt the choice of techniques towai-dhigher labor intensity in production of capital goods. Finally, a ne,-industrial development plan is being formulated.

- 2 -

This progress on so many fronts brings an assurance that otherissues of Mexican industrial development policy will be also closelywatched by the managers of the economic policy. These include the exchangerate, whenever the need to compensate for rising price levels inMexico would warrant adjustments, the related problem of incentives formanufactured exports, the biases of wage taxes and surcharg , whichmilitate against employment increases especially when combined with subsidiestied to equipment purchases, and financial deficits in many public sectorenterprises.

The many changes during the last two years have not altered but ratherhave strengthened the view of the authors of the report as to the importanceof three basic objectives for manufacturing sector development, and ofpolicies to meet those objectives. The present report was conceived preciselywith this purpose in mind, and the decision to make it more widely availablereflects the continued importance given to these objectives by the MexicanGovernment as well as the World Bank. The objectives, while economic intheir nature, have important social ramifications. They are: rapid andefficient growth of production of the Mexican industry, which applies both tothe non-petroleum as well as to the petroleum based branches of manufacturing,management of balance-of-payments related aspects of the manufacturing sectorand, last but not the least, the creation of productive jobs for Mexico'srapidly growing labor force. It is recognized, of course, that Mexico hasother objectives as well and that in some cases policies that would promotethe goals indicated above perhaps cannot be put into effect immediately and intheir "pure" form, because of the need to accomodate other objectives orconstraints. It is hoped, however, that any such compromise can be reducedto a minimum, so that the three objectives stressed here can be met as fullyas possible.

Nicolas Ardito-BarlettaVice President

Latin America and CaribbeanRegional Office

Currency Unit: Peso (Mex$)

Prior to September 1. 1976:

US$1.00 = Mex$ 12.50Mex$ 1.00 = us$0.80Mex$ 1 million - US$80,000

On September 1, 1976 the fixed parity of the pesowas abandoned. During 1977 the value of the pesohas fluctuated in the range of 20-30 pesos perUS dollar. As of March 1979 the values were:

US$1.00 - Mex$ 22.87Mex$ 1.00 - us$o.40Mex$ 1 million = US$43,733

Fiscal Year: January 1 through December 31.

GLOSSARY OF ABRREVIATIONS AND ACRONYMS

CANACINTRA Cgmara Nacional de la Industria de Transformaci6n

National Chamber of Manufacturing Industries

CEDI Certificado de Devoluci6n de Impuestos Indirectos

Certificate of Reimbursement of Indirect Taxes

CFE Comiai6n Federal de Electricidad

Federal Electricity Commission

CONASUPO Compaaia Nacional de Subsistencia Popular

Public Corporation for distribution of low-priced

basic food products

FIDEIN Fideicomiso de Conjuntos, Parques, Ciudadea

Industriales y Centros Comerciales

Trust Fund for Industrial Parks and Cities

and Co_ercial Centers

FOGAIN Fondo de Garant!a y Fovento a la Industria

Mediana y Pequenia

Fund for Promotion of Smell and Medium-sized

Industries

FOMYX Fondo para el Fomento de la Exportaciones

de Productos Manufacturados

Fund for the Promotion of Manufactured Exports

POUIR Fondo Nacional de Fosento Industrial

Fund for Industrial Promotion

FOhIP Fondo Nacional de Estudios de Preinversi6n

Fund for Pre-investment Studieg

FTE Free Trade Equilibrium (refers to exchange rate)

xPES InStituto de Eatudion Politicos, Econ&icos y

Social..

Institute of Economic, Political, and Social

Studies (analytical arm of the PRI, Mexico's

principal political party)

IME Institute Mexicano de Comercio Exterior

Mexican Foreign Trade Institute

INFONAVIT Instituto del Fondo Nacional de la Vivienda para

lo Trabajadores

Workers' Housing Fund

SIC Secretaria de Industria y Comercio

Ministry of Industry and Co merce

SICARTSA Siderurgia Lazaro Cardenas, Las Truchas, S.A.

Lazaro Cardenas - Las Truchas Steel Company

SmI Small and Medium Scale Industry

All monetary values are expressed in US dollars, unless otherwise noted.

MEXICO

MANUFACTURING SECTOR: SITUATION, PROSPECTS AND POLICIES

TABLE OF CONTENTS

Page No.

SUMMiARY ....................................................... 1

ANALYSIS . ................................................ 9

I. FOH(ElGN TRADE POLICIES. 9Exports .10Imports and protection .15Net protection and export incentives ............ 18

Choices for the Future .21Conclusions .28

II. PUBLIC AND FOREIGN-OWNED ENTERPRISES .9

Public Sector Enterprises .29Conclusions. 34Foreign-Owned Enterprises .36Conclusions .39

III. INDUSTRIAL FINANCING .41

The Financial Situation .41Conclusions .43

IV. TECHNOLOGICAL AND SECTORAL ISSUES. 45

Employment and Wage Policy .45Small and Medium-Scale Industry (Summary) 148Cal,ital Goods (Summary) .4Regional Development. 8

Annex I: Tables and Charts .66

Annex IT: Technical Note: Free Trade EquilibriumExchange Rates ............................. 83

Annex III: Mexico's Industrial Structure. 2

Annex IV: Small and Medium-Scale Industry .102

Annex V: Capital Goods ........... ....... 122

SUM4ARY

1. Over the last several decades, manufacturing has grown rapidly inMexico and today plays important roles in employment, import substitution andexports, and through its large impact on the economy as a whole. In 1970,the last ;ear for which complete census estimates are available, manufacturingaccounted for approximately 23 percent of GDP and employed 17 percent of thelabor force. In 1975 the share of GDP was still 23 percent. 1/ Growth in thevolume of manufactured output was 9 percent per year during the 1960s, con-siderably more rapid than the 7 percent per year growth in GDP. During1970-1975 manufacturing growth slowed to 6.2 percent per year, only slightlyover the annual GDP growth rate of 5.7 percent. Development of the sector hasfollowed a pattern common to several other large LDCs, with import substitu-tion almost complete in consumer goods (both durable and nondurable), less soin intermediate goods and least well advanced in capital goods. (See Table1.1 and Annex III. For more details on Mexican industrialization, see Aspra,1977; Nacional Financiera, 1971; Solis, to appear; and Villarreal, 1976.)

2. Efficiency, measured by international price comparisons, presentsa mixed picture. Average price levels for manufacturing as a whole were17.9 percent above international levels in 1960, 15.6 percent above in 1970,and 19.0 percent above in 1975. 2/ (These figures are net of estimated pesoovervaluation of 6.0, 2.8, and 18.4 percent in the three respectiveyears. Realized nominal protection of manufactured goods, based on pricesconverted at the official exchange rate -- i.e, including peso overvaluation --is estimated at 25.0, 18.8 and 40.9 percent. See Annex II.) Thus the averageefficiency of the sector compares well with other large import-substitutingLDCs, where protection has been considerably higher, but not so well with themore open, specialized economies. Moreover, the averages in Mexico hide afairly wide variation; many processes are highly inefficient, as shown both byprice coumparisons and by plant visit analysis. In a comparison of prices of394 products in 1975, 52 products (13 percent) had prices more than 50 percentabove international levels and 26 of these (7 percent of the total) werepriced at more than double the international levels. (These price differen-tials also are net of overvaluation, estimated at 18.4 percent in 1975.) Thisscattered inefficiency is protected by an import licensing system whichvirtually ignores price differentials in its usual refusal to permit theprivate sector to import goods that are produced domestically.

1/ Data on the different variables are not collected on a consistent basisand hence the estimates of shares may not be accurate.

2/ Throughout this report, measures of protection are based on estimatesof how much Mexican prices exceed international prices. The quantitymeasured therefore reflects how much Mtexican producers actually takeadvantage of various protective devices. Estimated changes over timein protection may be biased downwards because the 1960 study made moreadjustments for quality than did the 1970 one, while the 1975 studymade none. Thus protection may have increased somewhat more over timethan the estimates indicate.

-2-

3. Export performance of manufacturing has also been mixed. In 1975,

the value of manufactured exports (including total value of export sales ofassembly industries -- maquiladoras -- which accounted for half of the total)amounted to $2,090 million. At 12.50 pesos per dollar this was equivalentto 2.6 percent of GDP and 6 percent of gross valuec tf domestic production ofmanufactures. (Exports were depressed in 1975 because of the -ecession inthe United States and the overvaluation of the p-su. In 1974 exports hadbeen somewhat higher.) Manufactured exports g-;ew very rapidly in the 1970-74period -- about 26 percent per year in real terms -- but the level they at-tained is still Ic'. for a country at Mexico's stage of development. Most ofthese exports came about in response to special situations such as the in-crease in assembly plants of US firms, or special programs such as the auto-motive parts exports that are required of the Mexican automotive industry.The rapid growth in manufactured exports occurred in spite of Mexico's over-all policies which, except for these special cases, implicitly discriminatedagainst manufactured exports. In 1975, disincentives to manufactured exportsincluded the overvaluation of the peso estimated at 18.4 percent, as well asthe higher cost and lower quality of inputs (owing to protection and tosales taxes on inputs), as well as sales taxes on exports. These disincen-tives together are estimated to have been equivalent to an implicit tax onexports of some 26 percent. Positive incentives including sales tax reim-bursements under the CEDI scheme, low-interest export financing by FOMEX, andsomewhat better-than-average access to import permits for inputs, are estimatedto have been equivalent to only about 16 percent of what sales revenue wouldhave been in the absence of any incentives or disincentives, even when thevalue of CEDIs are increased to reflect that they are not subject to incometax. Thus net incentives for manufactured exports in 1975 were negative,about minus 10 percent.

4. The situation as of mid-1977 is somewhat better, as a more realisticexchange rate plus restored CEDIs reduced net disincentives to close to zero.Mexico appears to have great potential as an exporter of manufactures, withher advantages of natural resources, abundant labor, growing industrialsophistication, and closeness to the large market of the United States. Thispotential is suggested by the growth in manufactured exports that has alreadyoccurred, and is confirmed by the mission's analysis. Better policies wouldhelp to develop this potential.

5. In recent years, the whole package of Mexico's foreign trade policies(protection, export incentives and disincentives, and the exchange rate) hasnot been fully appropriate either for promoting sustained and efficient growthin output and employment or even for managing the balance of payments.Policies that give greater promise of meeting these goals incluae (a) a higherreal 1/ exchange rate (in terms of pesos per dollar) than in the past, maintainedat a stable real level by reasonably stable prices if possible or otherwise

1/ Throughout this report, "real" means net of any effects of inflation,i.e., in terms of constant prices. Keeping the exchange rate stable inreal terms therefore means adjusting it in proportion to any changes inthe ratio of Mexican prices to international prices.

- 3 -

by frequent adjustments, and (b) low import protection and commensuratelyadequate net export incentives for manufactures, with low dispersion amongproducts. Since September 1976 the exchange rate has moved in this direction.As to import policy, low and more uniform protection could only be achieved bysubstantial liberalization or complete removal of the import licensing system,since this system affords potentially very high protection and thus can beused to shelter very great inefficiencies where they exist. For exports of

manufactures, the cancellation of sales tax reimbursements under the CEDIscheme, and price increases, have offset the positive effects of the higherexchange rate; as of December 1976 net export incentives for manufacturesare estimated at minus 14.0 percent, which is even more negative than in1975. Export profits for most Mexican manufacturers were still too low tomotivate sustained growth in a wide range of exports. The restoration ofCEDIs announced on April 1, 1977 will wipe out most but not all of the netnegative incentives.

6. Placing greater reliance for both protection and export incentiveson a higher exchange rate and keeping that rate constant in real terms couldhelp increase both import substitution and exports. This, in turn, wouldincrease growth in total production and employment. tMoreover, growth underthis strategy would be more efficient, because incentives would be more equalamong products. Manufacturing as a whole still would, and should, be promotes,but the strategy would induce somewhat more specialization within the sectorin those products that can be produced most efficiently. The strategy wouldalso permit fuller utilization of capacity, greater scale of production, ai1dhence reduced costs. Gains in quality would also result from reduced procec-tion and greater exposure to export markets, and thus Mexican consumers wouldbenefit in terms of both price and quality.

7. The possibility of greatly increased exports of petroleum andpetrochemicals opens up a new option for Mexico's foreign trade policy. Theincreased revenues from these exports can be used to relax constraints ondomestic demand and investment, and hence to facilitate faster growth of GDPand employment. To do this, the peso/dollar exchange rate must be maintainedat or near its present level in real terms, and other export incentives mustalso be maintained (or strengthened). Then not only petroleum products butother exports will grow, the total increase in foreign exchange earnings willbe larger, GDP and employment will increase and the additional foreign exchangecan be used to pay for the additional imports that will be demanded. Thedanger to avoid is allowing incentives to increase other exports to weaken.This weakening would occur if the increased foreign exchange earnings frompetroleum induced the authorities to allow the dollar value of the peso toappreciate in real terms, to reduce CEDIs, etc. Such actions would reduce theprofitability of other exports, with the net effect of substituting petroleumfor other exports with no gain in GDP or employment.

8. Employment and wage policy, in this report, are analyzed only fromthe viewpoint of the manufacturing sector. In this limited context, the mosteffective measure to increase employment would be the foreign trade policiesjust mentioned. These policies would promote both import substitution and

- 4 -

exports of products Mexico can produce efficiently, which should imply muchgreater use of Mexico's abundant supply of labor. Another complementary ap-proach would be to improve support of small-scale industry, through greateraccess to credit and technical assistance as well as the improved access tomaterial inputs that would result from liberalization or abolition of importlicensing. .lso, fringe benefits that are financed from taxes or othercharges that are proportional to wages add as much as 50 percent to basic wagecosts. These burdens, combined with other labor laws that make firing orlaying off workers very difficult, greatly increase incentives for employersto substitute equipment for labor. Shifting the financing of some fringebenefits to taxes on value added or on income, in place of taxes or othercharges that are proportional to wages, would reduce the cost of labor topotential employers. This would increase employment, and through it, equity,as the relatively high-paying jobs typical of the manufacturing sector becomeavailable to a greater part of the Mexican labor force. Finally, the largewage increases of 1976, which were far above price increases and productivitygrowth, could rapidly erode Mexico's competitiveness if repeated in thefuture.

9. Fiscal policy is treated only partially in this report, but isimportant for the objectives dealt with here. (Fiscal policy will be dealtwith in greater depth in the report being prepared by the economic missionthat visited Mexico in April/May 1977.) Large public sector deficits havefueled inflation, which in turn has made Mexican exports less competitive, hasled to greater use of import licensing to counteract the fall in the real pesoprice of imports, and has negatively affected saving and financial intermedia-tion in Mexico. Moreover, to help finance the growing public sector deficitsof recent years, credit has been withdrawn from the private sector. Thusinadequate fiscal discipline in the past has reduced industrial investment andgrowth, efficiency of production, and exports. Reversing these trends isimportant for the future. Moreover, the adoption of foreign exchange policiesto increase output, exports, and employment (as summarized in paragraphs 5-7)would increase the need for managing public finances in a non-inflationarymanner. Analysis of the details of a sound fiscal policy is beyond the rangeof this report, but one important aspect could be improving the management ofpublic sector manufacturing enterprises, especially requiring them to cover afixed share of their current expenses and investment requirements, so as toincrease their incentives to cut costs and to adjust prices to cover reason-able costs more fully.

10. A return to steady industrial growth requires controlling the infla-tion that has been accelerating for the last few years, contributing to theclimate of uncertainty that had brought domestic private investment in Mexicanmanufacturing to a virtual standstill. The Mexican government is now takingsteps to reduce inflationary pressures. The mission's analysis of the manufac-turing sector suggests that an approach to price stability involving restraintby government, management and labor should consider: (a) A sound fiscalpolicy, as mentioned in paragraph 9. (b) Reduction of the high protection forsome products permitted by import licensing, combined with tariff revisions to

rationalize the system, would benefit consumers by doing away with the shelter-ing of the few highly inefficient producers that take advantage of the licens-ing system to pass on their high costs by raising prices in the domesticmarket. (c) Changes in taxation to tax away some of the increased profitsthat could result from the changes in foreign trade and wage policies, and toincrease motivation to re-invest most of the rest of such profits. (d) Notallowing real wage increases to exceed productivity gains, especially for thenext year or two.

11. Many public sector enterprises in Mexico function well. However,some others are a significant drain on public resources because of high pro-duction costs and low product prices. As a whole, public sector manufacturingenterprises have been incurring losses of 2 to 4 percent of net worth in eachof the last few years. To increase the contribution of public sector enter-prises to Mexico's development, the management situation which permitted thisshould be reviewed, and the recent Mexican Government reorganization seemsdesigned, at least in part, to do this. Another important aspect of theperformance of public sector enterprises is their virtually unlimited accessto duty-free imports, especially of capital equipment. This is one of theprincipal causes of lagging development in capital goods production in Mexico.These policies are also responsible, in part, for the large debts that somepublic sector enterprises have accumulated. Equity contributions by thegovernment would be useful to restore financial health to enterprises thatare basically productive, while increased fiscal discipline as required bythe recent administrative reform and other laws and regulations should guardagainst repeating these problems.

12. Private foreign investment has played a growing and useful role inMexican development, and can continue to do so in the future. The restrictionon foreign ownership to 49 percent of equity (less in some branches ofindustry) is sometimes relaxed if the investment is in a sector or regionjudged particularly important to the country's development. Explicit publicnotice of such relaxation in specified conditions, rather than by ad-hocimplementation, might help to make the policy more effective. Also, thestrategy now being pursued of promotion of tripartite joint ventures, bypublic, domestic private, and foreign capital, offers many advantages andshould be strengthened.

13. Mexico's well-developed system of financial intermediation has beenbadly set back during the last few years. Credit available to private indus-try has been doubly squeezed, by a drop in the mobilization of savings and bya rise in the share of total credit going to the public sector. These trendshave reduced credit outstanding to the private sector as a whole from 22 or23 percent of GDP during 1970-73, to 15 percent of GDP in 1976. The privateindustrial sector has been squeezed even further, as agriculture and commercehave maintained their shares of the total. Credit outstanding to manufactur-ing enterprises dropped from 36 percent of value added in manufacturiie in1969 to 32 percent in 1975; in 1976 it appears to have continued to fail, atan even faster rate. This credit squeeze could be reversed by reducing thepublic sector deficit, restoring reasonable real interest rates paid todepositors, and managing foreign trade policy so as to increase confidence in

-6 -

the peso. The Bank of Mexico seems to be aware of the need to provide ade-quate working capital to help firms affected by the adjustments to higherexchange rate, price increases in public services, etc., and that the situationrequires careful monitoring and prompt action to avoid unnecessary and costlyfailures.

14. Taking a long-run view, Mexican industry has been growing and muchof it is reasonably efficient. However, in the last few years the situationhas been considerably less favorable. Compared to most of the past fewdecades, the 1974-76 period has seen increasing inflation, declining invest-ment, restricted access of the private sector to credit, and wage increasesthat were more rapid and less related to productivity growth. Since August31, 1976 the abandonment of the peso-dollar parity of 12.50 to one, andsubsequent instability in the exchange rate, prices and wages, had producedconfusion and a crisis of confidence in the months that followed. Mexiconeeded a new set of policies that both in fact and in appearance confront boththe short-run problems and the longer-run needs of the economy, providing areturn to healthy growth. This confusion and air of crisis seem now to havepassed, as the basic soundness of the economy, the tradition of good perform-ance in the past, and many of the actions the new Government has already takenor has declared its intention to take increase confidence in Mexico's future.

15. One of the problematical aspects of the situation when the missionvisited Mexico in November 1976--perhaps difficult to avoid in that transi-tional period--was the lack of a coherent set of policies. Would wage andprice increases be allowed to erode the hoped-for benefits of the devaluationsof the peso? How can the competing claims of workers, public sector enter-prises, private business, and the government itself be resolved in a way thatreduces inflation and allocates resources to where they are needed and wherethey would be most productive? How can the words and the actions of thegovernment help to increase confidence, continue to attract both domesticand foreign saving, and invigorate investment? Any report must, necessarily,discuss policy measures in sequence. But the measures are dependent on eachother for success, and must be so designed. The sequential nature of theexposition should not be mistaken for a lack of interrelations between theindividual items.

16. Text Table 1 presents a brief overview of the policies discussedin this report. The three overall objectives that orient our analysis arelisted across the top: efficient growth, balance of payments management,and employment. From top to bottom are the major policy areas studied:the exchange rate, import controls, export incentives, prices, wages andlabor policy, public sector enterprises, private investment both foreign anddomestic, and industrial credit, as well as the two more narrowly definedparts of the manufacturing sector that were studied in more depth: small andmedium scale industry, and capital goods. Entries in the table summarize themeasures suggested for consideration, and their likely effects.

17. Text Table 1 contains several examples of the interdependence ofpolicies. To cite just one here: Removal or substantial liberalization ofthe import licensing system would probably increase imports to some extent.

-7-Text Table 1

MEXICO: OVERVIEW OF POLICIES SUGGESTEDFOR CONSITDERATION

O B J E C T I V E S

Policy AreasEfficient Growth Balance of Payments Employment and Income

hanagament Distribution

Exchange Rate:Keep rate at or near equilibrium Creates export incentives Restores confidence and Promote exports and import

in order to substitute for most and protection against brings both capital and substitution in all activi-

protection and export incentives imports )hile avoiding current accounts more ties; thus increasing em-

and to manage balance of payments price distortions and need toward balance even at ployment. Available income

at a high GDP growth rate; keep for import controls that higher growth rates. increases and its distribu-

real value more or less constant would otherwise lead to Eliminates implicit tax tion becomes more equitable,

in future. A level in the range inefficiency and lagging on exports that stemmed based on real contributions

of 20 to 22 pesos per dollar, at productivity; increases from overvalued peso, and to growtb rather than on

December 1976 prices, could be import capacity enabling thus increases exports. distorted incentives.

appropriate with other measures growth to accelerate.suggested here.

Import Controls:Dismantle or greatly liberalize Strengthen role of prices Probably increase imports. Limit price increases and

licensing system in a phased in resource allocation; However, higher exchange thus help to maintain con-

sequence starting with inputs spur to increased efficien- rate and tariffs will limit sumers' purchasing power.

into producer goods. Rational- cy. Improve access of these, and greater exports

ize tariff system to provide manufacturers to inputs will more than pay forprotection averaging, perhaps, at reasonable cost and them.10 to 15 percent for manufac- quality.turing. Eliminate waivers ofpublic-sector tariff payments.Create an administratively ef-

fective system of drawbacks onimport duties for exporters.

Export Incentives:Fquilibrium exchange rate plus Exports would be products Reverses two negative as- Increased demand for labor

somewhat stronger CEDIs; main- which are produced effi- pect of past policies, by in manufacturing and in alltain incentives indefinitely. ciently. making export profitabi- export activities; indirect

Since import substitution lity (a) high and (b) nearly effects further increase

opportunities are becoming equal to that of domestic employment throughout tne

limited, and Mexican manu- sales. Enables balance of economy.

facturing is maturing, a payments equilibrium at

shift toward export markets higher growth rate and with

is both natural and neces- more capacity to import.sary for continued rapidgrowth.

Prices:A sound macroeconomic policy, Relative prices allowed to Helps to keep exchange Limit price increases andbeyond the scope of this report, move closer to relative rate roughly constant, thus help to maintain con-is essential. Within such a costs (through liberaliza- in real terms at least. sumer's purchasing power.policy replace spotty price con- tion of imports and reduc- Maintains Mexico's compe-

trols and below-cost provision tion of implicit tax on titiveness in both domes-of goods and services from some exports that stemmed from tic and foreign markets.public sector manufacturing overvalued peso); willenterprises with economy-wide increase efficiency and realprice restraint, with target growth.level consistent with a modera-tely restraining fiscal andmonetary policy.

Wages and Labor Policy:Limit increases to productivity Reduce incentive to substi- Maintain Mexico's advantage Encourage employment ex-

growth during stabilization tute capital for labor; of lower labor costs vis- pansion both by use of labor

period. Replace annual renego- reduce costs of negotia- a-vie major trading part- as a substitute for labor-

tiations with 2 or 3 year agree- tions and uncertainty. ners; induce expansion of displacing capital equip-

ments providing for automatic ad- Greater use of available exports and of efficient ment and through greater

justment. Replace financing of supply of labor will in- import substitution. growth; improve income

some benefits from wage taxes crease output. distribution mong workers

by financing from general reve- dsrbto mn okrnues. flnanc from general reve-by

increasing the number of

jobs in industry (which arerelatively high-paying incomparison to the rest ofthe economy).

Text Table 1 (cont.)

0 B J E C T I V E S

Policy AreasEfficient Growth Balance of Payments Employment and Incose

Management Distribution

Public Sector ManufacturingEnterprisesPartly replace financing of defi- Motivates greater effi- Reduced inflation will makecits and expansions through ciency in operation and balance of payments manage-

Treasury funds by revenues of keep prices from falling ment easier.

the enterprises. Remove waiver below costs; reduce defi-on import duties for inputs. cit of public sector.

Reduced demand for creditfrom public sector willincrease supply to privatesector.

Private InvestmentReplace subsidies through cheap- Restore incentives to in- Increases employment by

er access to equipment and vest in efficient sectors reducing incentives to

imported inputs, by temporary through (a) better access substitute capital for

income tax relief (where to imported inputs, (b) high- labor and further by in-

subsidies are warranted); chan- er export profits, (c) ten- creasing investment.

nel employer's gains from porary corporate income tax, Promote equity by discoura-

wage restraint and export prof- relief in areas where sub- ging luxury consumption.

its into productive uses sidies are needed and (d)through interest rate, tax and wage restraint: thesecredit policies that favor measures compensating for

savings and reinvestment while higher costs of some equip-discouraging luxury consumption, ment and other current in-

puts. Alleviate creditsqueeze.

Foreifn 1pvestment:

Apply 49% participation limit Continue to attract needed Maintain or increasewith flexibility; mske permis- capital and technology, foreign capital inflow;

sible relaxation explicit in facilitate purchase of

cases such as investment in technology where needed

priority sectors or regions. (e.g. in capital goods).

Continue to promote tripartite Motivate investment for

joint venture with domestic export markets. Improve

private and public investors. access to export markets.

Industrial Credit:Hieher real interest rates and Restore flow of savings to Maintain output; expand Maintain and expand em-

stable real value of peso. Reduce financial system; restore investment for export ployment in efficient

public sector deficit. Assure share of private sector in production and efficient enterprises that would

adequate flow of credit for work- access to savings; maintain import substitution; otherwise fail for lack

ing capital, output by avoiding squeeze reduce new foreign in- of credit; promote equity

on working capital. debtedness by expanding the by allocation of credit

the flow of finance from based mainly on efficien-within Mexico. cy and future potential,

rather than existingwealth or foreign connec-tions.

Small and Medium Scale Industry:Increase access to credit and Remove constraint to growth Provide increased employ-

technical assistance, especially of small-scale sector. ment and increased rewards

for smaller firms. Liberalization of import to small-scale entrepre-

licensing will also move neurs.

in this direction.

Capital Goods:Eliminate privileged access of Move towards Mexico's compa- Substitute for imports Expand production in a

public sector to imports; provide rative advantage in this where domestic production sector with a relatively high

moderate tariff protection; sector, is not too costly; increa- labor/output ratio.

analyze growth possibilIties sed specialization should

for intermediate inputs and end also increase exports.

products; promote new projects

and assist existing firms ac-cordingly.

- 9 -

However, avoiding overvaluation of the peso, eliminating large-scale exemp-

tions from paying tariffs, and providing moderate tariff protection forproducts where tariffs are now low or zero because of reliance on refusal ofimport licenses could contain any increases in imports within safe levels.The same exchange Late policy plus restoration of CEDIs at an adequate levelcould increase exports by more than enough to pay for the increased imports.This policy package would induce growth in output in efficient enterprises(and in particular could provide part of an appropriate environment forpromotion of efficient import substitution and exports of capital goods). Atthe same time, the import liberalization could help to restrain unreasonableprice increases and help maintain consumers' purchasing power in the face ofwage restraint, and is in itself needed to cut costs and provide access toinputs of good quality and reasonable price, in order to promote exports.

ANALYSIS

I. Foreign Trade Policies

18. This set of policies includes the exchange rate; import tariffs,permits, and other regulations; and export incentives and disincentives. Itis assumed that the important goals to be met are (a) in the short run,helping to increase confidence in the peso and in the economy, and (b) inboth the short and the longer run, managing the balance of payments and in-ducing efficient growth in output and in employment.

19. The key themes of the mission's suggestions on foreign trade policyare increasing generalized incentives for exports of manufactures, and general-izing and rationalizing the already strong but uneven incentives for importsubstitution. Mexico's manufactured exports have been growing rapidly, butare still only a very small share of Mexican manufacturing production. Thecountry has great potential for continued growth of exports of manufacturedgoods, which could be realized by better exploiting its growing know-how,abundant labor, natural resources, and proximity to the US market. A strongerexport orientation for all Mexican manufacturing could serve many importantpurposes. (a) More exports are needed for managing the balance of payments,including the severe debt service burden of the next few years. Even importsubstitution that is efficient in the long run will not help much in the nextyear or two because most remaining opportunities for import substitution inMexico would themselves require considerable imports of equipment and somecurrent inputs. (b) More exports are needed to provide employment; exportsprovide markets for additional production and many export products that wouldappear under generalized incentives would be more labor-intensive than manu-facturing on the average. (c) Finally, such exports almost by definition aregoods which Mexico produces efficiently and thus they would contribute to agreater growth of output in real terms.

20. Mexico's present system of protection through licensing providespotentially very high protection to many manufactured products, and less to

- 10 -

others. The system insulates Mexican producers from motivation to cut pro-duction costs or to increase quality. This allows considerable inefficiencyin domestic production, most of which could be eliminated if motivation weresufficient. Some of this inefficiency consists of producing goods in which,at least at present, Mexico cannot be competitive. But by far the largestpart of the inefficiency consists of higher costs and/or lower 1uality thatcould be improved upon if the producers had to compete with imports or ifexport incentives made competing in export markets more attractive. To inducegreater efficiency, Mexico could increase access to imported products wheredomestic costs are unreasonably high, and also increase the profitability ofexports. This would permit more Mexican producers to increase volume andprofits through successful competition in international markets. Increases incompetition as well as more efficient specialization could induce fastergrowth.

Past Policies

21. The exchange rate was kept constant at 12.50 pesos per dollar from1954 until September 1976. Price increases in Mexico stayed about equal,grosso modo, with those of the United States and others of Mexico's tradingpartners until the early 1970's; protection against imports, as well as exportincentives, also did not change very much. Around 1971-73 this behaviourchanged. Prices rose faster in Mexico than in her principal trading partners.Mexican authorities chose to allow the peso to become overvalued, and to com-pensate for the overvaluation by increasing apparent protection and apparentexport incentives.

22. In any process of increasing overvaluation of a currency, with com-pensating increases in protection and export incentives, the true change inprotection (or in export incentives) is the net effect of the two oppositeevents: increasing overvaluation decreases protection (or export incentives)while the explicit measures such as more restrictive import licensing or taxrebates for exports provide compensating increases. For this reason, in thisreport we refer to the explicit measures as "apparent" protection or "apparent"export incentives, while the effects after estimated overvaluation has beennetted out are referred to as "net."

23. Exports: M4exico's manufactured exports have grown rapidly from alow base. Over the five-year period 1971 through 1975 they grew by 30 percentper year, of which about 12 percent per year was attributable to price in-creases and 16 percent per year represented real growth. Text Table 2 sum-marizes this growth.

- 11 -

Text Table 2Mexico: Manufactured Exports, 1970-1975 /a

(million dollars)

"Maquiladora"Year Assembly Plants Other Total

1970 218.8 353.5 572.31971 270.0 454.2 724.21972 426.2 574.9 1,001.11973 651.2 837.9 1,489.11974 1,032.9 1,242.9 2,275.81975 1,020.6 1,069.3 2,089.9

/a The figures exclude primary nonferrous metals, sugarand petroleum products. The full value of product ofassembly plant exports are reported, making them com-parable with other exports.

24. In relative terms these industrial exports are still rather small --

only 3 to 8 percent of those of European countries with populations roughlycomparable to Mexico's but whose income is three to six times as much (WestGermany, United Kingdom, France, Italy), and also very much smaller in percapita terms than manufactured exports from successful LDC exporters such asTaiwan, Hong Kong, The Republic of Korea and Singapore. However, Mexico'sindustrial exports, including assembly products, are roughly double those ofBrazil in per capita terms.

25. Nearly half of Mexico's manufactured exports come from plants thatassemble products for the US market based at least in part on inputs importedin bond from the United S-i.ates, taking advantage of special provisions in theUS tariff that limit import duties for such products to value added outsidethe United States. About two-thirds of assembly-plant exports consist ofitems such as electronic parts, television and communications equipment;clothing is a distant second.

26. Exports other than those of assembly plants are more diversified.Exports of non-electrical machinery, electrical machinery, and transportequipment industries have grown considerably, to $270 million (25 percent ofnon-assembly-plant manufactured exports) in 1975. Most of these exportsconsist of parts or components, led by automobile engines and parts, and mostgo to the United States. However, automobile parts exports are required ofthe automotive industry, and may not all be produced at internationallycompetitive costs (see paragraph 28). Chemical exports ($204 million in 1975-- 19 percent of non-assembly manufactured exports) are largely based on

- 12 -

natural resources such as sulphur, lead, zinc, and barbasco (used to producehormones); these go mostly to the USA and LAFTA countries. Textile exports,based on locally produced henequen and cotton, and food product exports, ledby molasses and simply preserved fruits and vegetables, are also important.In spite of the concentration of exports in a f.w sectors, _. _r . .*

sectors exporting 10 percent or more of their output in 1974 (the last yearfor which these comparative data are available) were basic chemicals, fertil-izers, and pharaceuticals--all principally based on natural resources.(Large food product exports were mostly sugar, not treated here as a manu-factured export.) (See Tables 1.2, 1.3, and 1.4 for more details.)

27. Manufacturing exports have been inhibited by a number of seriousdisincentives. The most important of these negative elements have been (a) theprogressively more overvalued exchange rate that prevailed through the 1970s,until the floating of the peso in September 1976, and (b) problems of highcost, low quality and unreliability of manufactured inputs, mainly owing toindiscriminate protection by the import licensing system. The overvaluedexchange rate squeezed export profit margins, as the peso value of exports waskept from rising while peso costs of wages and other domestic inputs rose. Atthe same time, some of the intermediate inputs produced in Mexico and protectedby refusal to grant licenses to import competing products were too expensiveor not good enough in quality to permit their use in competitive export pro-ducts. Other disincentives include (c) the inflexibility of some of the laborlaws: high costs of discharging workers and difficulties in achieving tempo-rary layoffs discourage investors from expanding their labor forces; (d) highcosts and delays of shipping through the main Gulf ports of Veracruz and Tampico;and (e) heavy use of discretionary measures in policies affecting exports:"deals" offered and rules applied vary greatly over time, and even among firmsin the same industry. A potential exporter cannot be sure what incentives hewill get, whether he will be able to import certain inputs, etc. The uncer-tainty that results is a great discouragement to investments to produceexports. Restrictions on imports, on the part of countries which would other-wise be buying more Mexican goods, are also an inhibiting factor.

28. Many exports that appeared in spite of these disincentives have beenbrought into existence by special policy measures. For example:

(i) Automobile manufacturers are required to achieve either exportsor increased domestic content in specified ratios to importedinputs in order to raise the numbers of vehicles they areallowed to produce each year. At least two-fifths of theexports are required to come from parts manufacturers. Accord-ing to one study, in 1974 Mexico's motor vehicle industry achieved$154 million worth of exports, consisting mainly of automobileengines and parts, compared to $498 million worth of imports.(Vazquez Tercero, 1976) To the extent that these exports arenot produced at competitive prices, the costs of subsidizingboth exports and domestic manufacture are borne by Mexicanconsumers.

- 13 -

(ii) Costs that processors have to pay for many natural resourceinputs are reduced, by various means such as export taxes,export restrictions, or price controls that hold prices inMexico below the world market price. The coverage of thesemeasures has varied; at one time or another they have extendedto most potential agricultural and mineral exports, includingindustrial inputs varying from zinc and sulphur to citrus andstrawberries. In the case of babasco, used to manufacturehormones, exportation has been prohibited outright. Suchmeasures, by lowering the costs of raw materials relative tothe market value of exports, contribute importantly to Mexico'sexports of manufactures based on natural resources. Costs areborne by primary producers whose sales prices are controlledor whose exports are taxed or restricted.

(iii) Industrial exports under accords with LAFTA countries--to whichMexico exported over $125 million of manufactures, narrowlydefined, by 1973 (see Table 1.4)--are based on mutual waiversof protection, giving these goods privileged access in marketssuch as Brazil or Argentina. Costs are borne indirectly byMexican consumers, who must pay high prices for other productsimported from Mexico's LAFTA partners in exchange.

(iv) Low-interest financing by FOMEX has been a significant helpto many exporters of manufactures. The advantage to exporterswho receive these loans, which are available for virtually allmanufactured exports and without excessive administrative diffi-culties, is on average equivalent to an additional 2 percent ofexport prices.

(v) Many enterprises consider it good policy to export toincrease their chances of being allowed imports, and manyothers export modest quantities at prices that may be wellbelow average costs, in order to achieve fuller utilizationof capacity. Some exports remain unprofitable in the longrun but are continued because they cover variable costs;thus some of the exports in recent years are a lagged effectof investments undertaken earlier when conditions were morefavorable.

(vi) Finally, the most important of the incentives that weregenerally available to exporters of manufacturers werereimbursements for payment of indirect taxes--CEDIs.

29. CEDIs, in effect from 1971 to August 1976, were the single mostimportant incentive to manufactured exports. These tax rebate certificateswere temporarily eliminated after the fixed parity of the peso was abandonedin August 1976, were later reinstated on a selective basis for industries thatcould demonstrate a "need" for them (this is an example of the ad-hoc applica-tion of incentives, which is much less effective than automatic across-the-board procedures), and were reinstated generally just as this report was

- 14 -

completed in April 1977. While CEDIs were in effect before August 1976,the producer for export received certificates worth 11 percent of the salesprice of exports if the domestic content (material inputs made in Mexico plusvalue added) of his product was 60 percent or more; these certificates couldnot be negotiated or transferred, but could only be used to pay taxes. Thistax rebate was not subject to income tax (which is generally 42 percent forcorporations) so that for many recipients the after-tax effect was equivalentto a 19 percent increase in their sales price. However, some exporters paylittle or no income tax. In calculations for this report the mission hasassumed that two-thirds of all CEDIs went to companies with sufficient incometax liability, so that on average the value of CEDIs was equivalent to a 16percent increase in the sales prices of exports. Under the old system, CEDIshelped exports considerably but had some shortcomings. For exporters whoseproduct consists mostly of purchased inputs and only very little of valueadded, CEDIs increased profit margins enormously, while for others with adifferent cost structure or with low tax liabilities, their value was small.The system did nothing to compensate producers of inputs that were incor-porated into exports by other producers, and the CEDIs given out bore verylittle relation to the net contribution of each export to the balance ofpayments, since the reward was the same whether domestic content was 60percent (which could mean much less in international prices) or 100 percent,and regardless of the extent to which the export used exportable inputs orimported capital equipment.

30. Under the new CEDI system decreed in April 1977, the value of thereimbursement varies from 25 to 100 percent of indirect taxes paid, dependingon (a) how much of the gross value of product represents value added (asopposed to purchased raw materials and intermediate goods); (b) the domesticcontent of the product, and (c) whether the exporter has increased his exportsin the last year. For example, if the product has only 30 percent domesticcontent, and the value added by the exporter is relatively low, the CEDI isonly 25 percent of the taxes paid. More domestic content means higher CEDIs;at 80 percent or above the exporter receives 50 percent of taxes back.Similarly, higher value added means higher CEDIs; high value added and 80percent or more domestic content earns the exporter 80 percent of his indirecttaxes. Finally, export increases can earn up to an additional 20 percent. Toreceive reimbursement for all of his indirect taxes, the exporter must have 80percent or more domestic content, high value added, and a 15 percent annualincrease in his exports.

31. Other export incentives are: (a) Administration of import and in-vestment licensing by SIC favored export activities. Requests for importlicenses were more likely to be granted, and were sometimes granted morequickly, if the need for the import was justified by a need to compete inexport markets. (b) In general there was increased official concern overmanufactured exports, as evidenced by various promotional activities such asthose of IMCE. (c) The Banco de Mexico appears determined to direct financingto export-oriented firms in the present credit squeeze.

32. With proper policies, Mexico appears able to become a major exporterof industrial products, on a scale many times as large as today, provided thatits industries are encouraged to specialize in what they can produce best.

- 15 -

This achievement would speed the nation's advance into the ranks of the indus-trial countries, not only through the exports themselves but also because thetypes of policy environment and managerial and technical efficiency neededto meet this challenge are also what Mexico requires to improve its productionfor the domestic market, to raise income and to increase employment.

33. Mexico's comparative advantage in manufactured exports appearsto lie especially in two broad areas. First, some manufactured exports canbe and are based on local primary raw materials; progress in these industriesdepends heavily on the associated primary producing sectors. Second, thereis an especially promising future in exporting products to the US that com-bine two features: substantial requirements for manual labor, and moderatetransport costs and/or need for fast delivery. In products for which trans-port costs are too high, Mexico cannot compete with US producers; wheretransport costs are very low, Mexico cannot compete on even terms with Asiancountries as a source of cheap labor. Mexico does enjoy special advantages inan enormous variety of exports subject to moderate transport costs, such assome building materials, furniture, other household items, a wide range ofmetal products and parts and assembly activities, perishable food products,and fashion-sensitive clothing requiring rapid delivery. While some ofthese exports may be specialty items produced in small batches, many otheropportunities depend on mass production of goods in which Mexico has a poten-tial cost advantage vis a vis the United States. To realize such advantagesrequires specialization within each industry, so that high volumes of outputcan be achieved. Examples where early success can be expected include motorvehicle parts, components for machinery and transport and electronic equipment,assorted simpler metal products, and glass products. However, specificationof the precise items is difficult to predict. The best approach may be toadopt generalized incentives and let the market indicate just where Mexico canbest compete and, more, to make the market stimulate the potential exportersto come up with better and with new export items.

34. Mexico's potential can be realized rapidly by embracing a strategythat has been followed in periods since World War II in a number of coun-tries, with excellent results -- West Germany, Italy, Japan, Austria, Fin-land, Norway, Greece, Taiwan, Korea and Singapore would be leading examples.The essence of this strategy is to create a stable policy environment witha strong government commitment to expand exports and keep them profitable.This requires giving producers access to the inputs and other help they needto be competitive, and having an exchange rate, relative to domestic wages andother costs, at a level where local prices appear low and the country becomesa really attractive place to invest and expand output. In this strategy theexchange rate becomes the main source of protection against imports as wellas of export competitiveness. By compressing the foreign currency value ofincomes, non-essential imports can be kept in check and, since export earningsgrow swiftly, the country can afford whatever imports of capital equipment andintermediate inputs are necessary.

35. Imports and protection: Mexican manufacturing has developed rap-idly and has diversified to a wide gamut of products during the last two orthree decades. By 1969 imports contributed only 10 percent of total supply of

- 16 -

manufactures in Mexico. Of non-durable consumer goods, imports were less than2 percent of total supply; for intermediate goods the share was 11 percent andfor durable consumer and capital goods together the share was 29 percent.(Nafinsa 1971). The share of manufactured imports as a whole increased inthe early 19709, but this was due to the overvaluation of the peso and toinventory speculation in anticipation of possible devaluation. Looking atsectoral detail, by 1974 imports were significant only in basic chemicals,capital goods, synthetics and plastics, and the miscellaneous category. (SeeTable 1.1).

36. This development was promoted in large part by a conscious policyof import substitution during the last few decades. Control of imports hasrelied more on quantitative controls than on tariffs. The percentage ofproducts for which import permits are required has risen steadily over thelast 20 years; from about 33 percent in the late 1950s, the percentage roseto 50 percent in the early 1960s, reached 75 percent in the early 1970s,and in November 1976 was about 85 percent. The percentage by value of actualimports that required licensing also rose, although less rapidly, from 28percent in 1956 to 74 percent in 1974.

37. The general principle of operation of the system is that importsthat compete with locally produced goods are not allowed. In some extremeinstances of high cost of the domestic product, the authorities have grantedimport permits. But as a rule they were prepared to allow substantial mar-gins of inefficiency - as reflected in the prices -- to protect goods pro-duced in MIexico. Of course domestic competition, the possibility of smug-gling and the increase in the size of the domestic market reduced inefficiencyin many established industries. Nevertheless, the erratic levels of protec-tion generated by the licensing system are reflected in the wide dispersion ofrates of protection, already noted in paragraph 2. Imports, moreover, havebeen subject to numerous exemptions from tariffs, most notably imports by thepublic sector and some imports of capital goods, so that tariff collectionswere only 6.5 percent of total merchandise imports. More than one-half ofimports (33 percent of private sector imports and 89 percent of publicsector imports) paid no tariff at all in 1975.

38. Actual protection as measured by international price comparisons,however, was higher. The apparent average level of protection of manufac-turing was 25 percent in 1960, 18.8 percent in 1970, and 40.9 percent in1975. The pattern of protection is typical: primary production receiveslow rates, traditional industry higher rates and "modern" consumer durablesstill higher rates. Unfortunately, the two-digit industrial classificationsthat were used in studies of protection aggregate products with widely dif-ferent levels of protection in Mexico, and therefore impede analysis ofappropriate groupings of products. For example, the two-digit sectors enjoy-ing the highest protection, on average, in 1975, were textiles, beverages,basic chemicals, synthetics and plastics, and cosmetics. However, thereally high protection is only evident at higher levels of disaggregation.High protection is scattered throughout most manufacturing sectors, usuallyfor a few products in each. This is the result of the licensing systemwhich grants protection with little or no rationale, other than to pro-tect domestic production, and with little or no regard for relative costs.

- 17 -

39. While protection did help to induce industrialization in Mexico, andindustrialization has been a key element in raising incomes, diversifying andincreasing exports, and modernizing Mexican society, there have been signi-

ficant costs associated with protection in Mexico. One way to estimate someof these costs, a- presented in Bergsman (1970), is to view protection asleading to higher prices owing to three different factors: (a) higher coststhat are unavoidable, in which case protection is sheltering industries which,at least at the time, cannot be efficient in Mexico; (b) higher costs thatcould be reduced, in which case the industries could be efficient in Mexicobut the producers are using protection to relax their cost-reducing efforts;and (c) monopoly returns, in which case the industries are efficient in Mexicobut the producers use protection to charge higher prices. Reducing protec-

tion would reduce all three effects, in the first case by replacing domesticproduction by imports while in the second and third case domestic productionwould continue but prices would be reduced. Estimates for 1960 place the sizeof the first effect at 1.5 percent of value added in manufacturing, and the

second and third combined at 11 percent of value added in manufacturing.This means that Mexican manufacturing could have produced much more outputif distortions induced by protection had been absent, with only very smallreplacement of domestic production by imports. Changes since 1960 suggest thatthe allocative costs may have risen; the total of these effects may be esti-mated currently at about 15 percent of value added in manufacturing, or over40 billion pesos.

40. Indiscriminate protection behind an import licensing system is alsoa major hindrance to manufactured exports. Such protection not only increasesthe costs of intermediate inputs but in many cases results in lowering theirquality. Experience in other countries suggests that real success in export-ing manufactured goods virtually requires that exporters have access to inputs

at world market prices.

41. Another kind of cost of protection is that incurred by the govern-ment in administering the licensing system and by the private sector indealing with it. Administratively, the licensing system causes some prob-lems for many importers but not in all cases. In general, if the import ispermitted its quantity is not limited. Thus, firms can import without restric-tion certain inputs or machinery which by no stretch of the imagination areproduced in Mexico. In other cases, firms resign themselves to using thedomestic input even if it is more expensive or of lower quality, adapt theirproduction processes to the situation, and pass the price or quality differ-ence on to the consumer. Administrative problems arise when it is not clearwhether the domestically produced good is "really" the same as the importedproduct. For these cases some firms and trade associations maintain staff of"expediters" and "public relations experts," and invest a substantial portionof the time of top management to "cultivate" the import licensing authorities.The Ministry of Industry and Commerce in turn employed about one thousandpersons and substantial computer time in the process of granting permits andother matters regulating imports. Of course firms that are too small or toofar away from the capital to become involved in the import permit processhave to buy from distributors, often at a substantial premium, or do without

- 18 -

imports entirely. Controlling imports by licensing discriminates againstsmall-scale entrepreneurs because they have less access to imported inputsand less ability to insure protection of their products by influencing theauthorities to deny licenses for competing imports. Capital goods productionis also very sensitive to the negative effects of licensing, because mostcapital goods are made of literally hundreds of parts which must meet certaintolerances or other quality standards. Uncertainty as to availability ofimports and mistrust of protected domestic suppliers lead producers of end-product capital goods to produce more of such parts themselves, at smallerproduction volumes than is economical.

42. Net protection and export incentives: The combined forces ofexport incentives and disincentives, protection, and exchange rate policycan be summarized in numerical terms. Measures of many of the relevantvariables are available only for 1970 and-1975, which is sufficient to showwhat happened: 1970, very roughly, is representative of the period 1960through about 1971; changes from 1970 to 1975 show the trend from 1972-73through August 1976. The analysis is summarized in Text Table 3 and Chart1.1. The estimates for all incentives and disincentives are expressed interms of equivalent effect on sales prices, so as to be comparable with eachother and with changes in the exchange rate. For example, a 6 percent increasein input prices would be expressed as (6) (.62) - 3.7 percent, if inputs were62 percent of product price.

43. From 1970 to 1975, apparent protection to Mexican manufacturing(as measured by price comparisons) rose from 18.8 to 40.9 percent. On theexport side, the apparent effect of all incentives and disincentives takentogether was changed from an implicit tax on manufactured exports of 12.0percent in 1970 to an apparent subsidy of 7.1 percent in 1975. This apparentsubsidy consisted of the positive effects of CEDIs (16 percent) and otherincentives (3 percent), offset by the effects of sales taxes (8 percent) andhigher input costs due to protection (5 percent). (See Annex II for details.)

44. As noted earlier the apparent increases in both protection and ex-port incentives were in large part compensation for an increasingly over-valued peso. Mexican prices were rising, relative to prices in her principaltrading partners. Moreover, Mexico's balance of payments deficit was increas-ing. Both of these required devaluation or some substitute; the Mexicanauthorities chose to increase protection and export incentives as an alterna-tive to devaluation. As a result, the apparent increases in protection andexport incentives were in large part illusory.

45. To make more meaningful estimates of levels of protection and ofexport incentives, the mission has estimated "free trade equilibrium" exchangerates for 1970 and 1975. These are the exchange rates at which Mexico's bal-ance of payments would have been at or near equilibrium if all protection,export incentives and disincentives were removed. Details of the methodologyare explained in Annex II. Estimates of protection or export incen-tives relative to this exchange rate, referred to as "net protection" or "netexport incentives," measure the net effects of all of Mexico's foreign tradepolicies, relative to a situation in which imports and exports are neither

- 19 -

promoted nor discouraged. These net estimates can also be compared overtime -- because the effects of any changes in overvaluation of the peso havebeen removed, the estimates measure net or true changes in protection orexport incentives. Changes in net protection or net export incentives canalso be approximated by changes in real effective exchange rates, as shownin lines 4 and 5 of Text Table 4, on page 25.

46. The estimated free-trade equilibrium exchange rate depends on whatother policies are in force. For example, it would be increased by greatergovernmental spending or by faster growth; it would be decreased by moreconservative macroeconomic policy or by increased exports of petroleum. Thusit is not necessarily the "right" exchange rate (this latter depends on theobjectives of policy) but simply the rate at which Mexico's balance of pay-ments would be in equilibrium given a particular set of other policies.

47. Overvaluation is estimated by this method at 2.8 percent in 1970and 18.4 percent in 1975. 1/ When the apparent levels of protection againstimports of manufactures (18.8 percent in 1970 and 40.9 percent in 1975) arereduced to net out overvaluation, they fall to 15.6 percent in 1970 and 19.0percent in 1975. On the export side, net export incentives for manufacturesare negative in both years: -14.4 percent in 1970 and -9.5 percent in 1975.

48. These policies kept Mexican export profitability low, and certainlymuch lower than the profitability of sales within Mexico. In 1975 a typicalmanufactured product worth, say, $100 in the world market, could be producedand sold in Mexico for the peso equivalent of $118.40. 2/ The same Mexicanproducer would receive the peso equivalent of only $90.50, however, if heexported his product. If his profit margin on the domestic sale was 20percent, exports would have implied a loss of $4.22 per unit.

49. These conditions were not much better as of December 1976. Forexports, the depreciation of the peso added about 60 percent to unit revenue,but the loss of CEDIs plus labor and materials cost increases since 1975 wereequivalent to an even greater drop in unit revenue. Net export incentiveswere still negative, at about -14.0 percent. On the import side, net realizedprotection was about the same as in 1975, 3/ as was the potential protection

I/ The estimated overvaluation is slightly less than other approaches havecalculated. Reasons for this are explained in Annex II. Briefly,the two main reasons are that the estimates take into account the (im-portant) effect of protection on raising costs of inputs (an effect thatwould be removed in free trade, and thus increase exports) and also theeffect of structural changes such as import substitution and exportgrowth in sectors such as petroleum and tourism.

2/ Valuing the peso at its estimated equilibrium level.

3/ Approximated by changes in wholesale price indices.

- 20 -

Text Table 3

Mexico: Exchange Rates, Protection and Export Incentives:1970, 1975, and December 191b

(in current prices)

197°~ l^75 Derember

(pesos per dollar)

1. Exchange rate 12.50 12.50 20.21

2. Apparent protection for manufactures (in percent) 18,87 40.9Z 25,5% a!

3. Apparent export incentives for manufactures (in -12.0%percent) -9.3% e/

Effective exchange rates for:4. imports of manufactures b/ 14.85 17.61 25.36 a!

5. exports of manufactures c/ 11.00 13.39 18.33 e/

6. Ratio of effective rate for imports to effective

rate for exports 1.35 1.32 1.38

7. Overvaluation (in percent) 2.8% 18.4X 5-4%

8. FTE exchange rate d/ 12.85 14.80 21.31

9. Net protection for manufactures (in percent) 15.7 19.0% 19.0% a/

10. Net export incentives for manufactures (in percent) _14.4% -9.5Z -14.0% e/

a/ Apparent protection for December 1976 was approximated by applying changes inwholesale prices in Mexico, relative to wholesale prices in the United States,

to protection in 1975.

b/ Effective exchange rates for imports are defined as the average ratio of pricesof imports to prices in the domestic market, and thus reflect average realizedprotection.

c/ Effective exchange rates for exports include the estimated effects of variousincentives and disincentives, all expressed in terms of how much sales priceswould have to change to have the same effects on profits after taxes. SeeAnnex II.

d/ The estimates of the FTE exchange rates for 1970 and 1975 are explained inAnnex II. For 1976, the estimate assumes that the rate changed exactly

in proportion to price changes in Mexico relative to price changes in theUnited States, from a 1975 base.

e/ CEDIs, not in effect in December 1976, are not included. Their restoration inApril 1977, plus the movement of the exchange rate to 22.40 per dollar (approximate-

ly the same changes as in Mexican prices during January-March 1977), reduce netexport disincentives to close to zero.

Relationships among the items in the table are as follows:

line 4 = line 1, increased by percentage shown in line 2line 5 = line 1, increased by percentage shown in line 3line 6 = line 4 divided by line 5line 8 = iine 1, increased by percentage shown in line 7line 9 = percentage by which line 4 exceeds line 8line 10= percentage by which line 5 exceeds line 8

- 21 -

afforded by the licensing system. Sales in the domestic market were stillmuch more profitable than export sales, as the effective exchange rate formanufactured imports remained more than one-third higher than that for manu-factured exports.

50. The restoration of CEDIs, although at a lower level, announced inApril 1977 will improve incentives for manufactured exports considerably. Ithas not been possible to take the new system of CEDIs into account because thedetailed regulations were not available when this report was completed.

Choices for the Future

51. Mexico's foreign trade policy is now in transition. The value ofthe peso is at a more realistic level, relative to 1974 and 1975, and perspec-tives are improved. To move toward the goals assumed here (increase confi-dence, manage the balance of payments, induce efficient growth of manufactur-ing output and employment) further steps might prove useful, but these wouldtake some time to put into effect. Therefore the discussion focuses both onalternative policy packages that could be targets for two to three years fromnow, and also on choices for the transition.

52. Targets: Three aspects of foreign trade policy would be importantin achieving the stated goals. First, confidence that the real value of thepeso will be kept more or less stable is crucial for sustained export growth. 1/Potential exporters know that no system of tax rebates or other promotionaldevices can compensate for continously increasing overvaluation of thecurrency. 2/ Should the Government choose to establish a new fixed pesovalue, Mexico would return to the fixed-parity situation that its people areused to. Obviously, a fixed parity can be maintained only when the Mexicaneconomy has achieved price stability relative to its trading partners. If,however, a very rapid stabilization strategy is seen as technically notfeasible or if its social or economic costs would make it not worthwhile, itmay be better to recognize this at once and make a commitment toward a lessrigid anti-inflation program plus an adjustable parity for the peso, at leastfor a period of a few years, so that an appropriate real value can be main-tained. The worst of both worlds would be to try to fix a new nominal value

1/ Although z- -'--hange rate is obviously a macroeconomic policy instru-ment, it -;o important to manufacturing sector development that it isincluded -his analysis. As with other measures, the purpose is toestimate th =-f -. ;s of alternative policies.

2/ The importance of tourism - ico's foreign trade is another r>- infor avoiding overvaluatiorn -he peso. Tourism exports (i.e.., moneyspent by foreiRn tourists in Mexico) and tourism imports as well (i.e.,money spent Lv Mexicans when they travel abroad) are sensitive to exchangerate differsaces, and effective schemes to cheapen the peso for foreigntourists or LO limit Mexican tourist expenditures abroad are difficultto implement.

- 22 -

for the peso but fail to stabilize prices enough to maintain it. Under afloating or crawling peg regime, the authorities may fear a loss of influenceon monetary variables (especially interest rates). However, the closegeographic and economic ties between Mexico and the United States and relatedfree flows of capital have already limited Mexico's influence on thesevariables, even with a fixed nominal value of the peso; it is not clear thatan adjustable parity would further reduce Mexico's flexibility in this respectto any significant degree.

53. Second, create a system of incentives that make exports profitable.To foster a strong and continuing growth of exports, profits on export salesmust be, at least, about equal to those on domestic sales, and Mexican busi-nessmen must be convinced that the government is committed to maintaining theprofitability of exports in the future. Sustained growth in manufacturedexports, to increase them above the small percentages of output shown in Table1.3, requires investment in plant and equipment to produce for export markets.Such investment in turn requires the prospects of continued reasonably highprofits. As concluded in paragraphs 61-65 below, an exchange rate in therange of 20-22 pesos per dollar in terms of December 1976 prices, with CEDIsgenerally available at face values equal to the effects of protection oninputs and of sales taxes, which act as disincentives to exports, is probablythe minimum necessary to motivate sustained growth in manufactured exports.Such an exchange rate would increase incentives both to import substitutionand to exports; this would help manage the balance of payments even with thelicensing system greatly liberalized or abolished, and promote more rapid andmore efficient growth in industrial output and employment.

54. Third, rely more on the exchange rate itself, and less on additionalmeasures for protection and export promotion. During the 1970s Mexico reliedless and less on the exchange rate itself, and more and more on protectionagainst imports and on incentives to export, to maintain realistic effectiveexchange rates. Two weaknesses of this approach have already been demonstrated:it is not good in keeping up with inflation, and it causes distortion becausethe protection and the incentives have stronger effects on some sectors thanon others. These distortions induce growth in less efficient industries, andpermit efficient industries either to gain very high profits or to relax andlet costs rise. The possibility of retaliatory actions by trading partners isa third weakness of the approach. The United States, which buys three-fourthsof Mexico's manufactured exports, has been increasingly imposing countervail-ing duties against measures it determines to be subsidies on exports.

55. The distorting effect of protection and export incentives is some-times intentional, as policy-makers seek to promote specific industries.Such measures can be desirable when based on well-thought-out national ob-jectives, externalities, learning-by-doing effects, etc. and applied inspecific cases after careful analysis leading tip a decision at an appropri-ate level in the government. But a system in which distortions are thenorm rather than the exception, and are determined by thousands of smalldecisions taken every year by lower level civil servants, is bound to leadto substantial inefficiency. This is exactly the effect of a generalizedlicensing system.

- 23 -

56. The first concrete steps to implement such a strategy have alreadybeen taken: the exchange rate is in the economically appropriate range, CEDIsare to be restored (albeit at a lower average level), and liberalization ofimport licensing has begun (albeit for only 884 items, many of which wereeither seldom imported or for which licenses were issued more or less onrequest; some 4,900 other items remain subject to licensing.)

57. Since the tariff system has long played a very small protectiverole in Mexico, it would have to be reviewed and adapted to function in theabsence of the licensing system. An important part of the overall strategyunder discussion is that protection against imports would come primarilyfrom the exchange rate. Tariffs would be kept low, but certain tariffs thatare now very low or zero could be raised slightly, especially for infant in-dustries such as capital goods. A structure of tariffs averaging, say, 10to 15 percent for manufactures, with protection for sectors with much undev-eloped potential at, say, 20 to 25 percent, might be appropriate as a targetto be achieved in several years. With the higher exchange rate, averageprotection as measured by the real peso cost of imports would fall only alittle, but the very high protection afforded some products by the licensingsystem would be ended.

58. Licensing or other restrictions could be retained for imports ofproducts deemed harmful or unnecessary. Even for luxury imports, however,the government might wish to consider whether the nation would not be betteroff if high excise taxes on luxuries (both imports and domestic products)replaced the present practice of refusal of licenses. This would permit thosefew people who are willing to pay exhorbitant prices to satisfy their importdemands, with most of the price they pay going to the public treasury.

59. The elimination of exemptions from tariffs for public sector agen-cies and for private sector importers of capital goods (implying also thatthese agencies not be automatically reimbursed by the Treasury for the tariffspaid) would help domestic producers of capital goods compete on less unequalterms with foreign producers. The objectives sought by those tariff exemptionsnow in effect -- export promotion, decentralization, and increased investment-- can be achieved by other means (such as temporary income tax relief) whichwould be at least as effective and would not lower the price of equipment andthus tend both to reduce employment (see paragraphs 126-130), and to dis-courage purchases from local producers.

60. The elimination of licensing coupled with tariff reform, includingelimination of tariff exemptions, would produce considerable revenue -- animportant consideration during a period of budgetary restrictions. In 1975the loss in tariff revenues due to exemptions alone was about Mex$ 6.5 billion.At estimated 1977 import levels, the changes recommended here would produceadditional revenues from tariff collection on private sector imports ofbetween Mex$ 9,000 million and Mex$ 14,000 million--roughly 10 percent of theexpected budget deficit. 1/

1/ This calculation uses tariff rates averaging 20 to 25 percent onmanufactured imports; the assumption is that the lower tariffs averaging10 to 15 percent would be apprqached over a period of several years.

- 24 -

61. The only exemption from paying tariffs that would help to achievethe goals assumed here would be on imports of goods that are re-exported.Giving exporters access to imported inputs at world market prices is an impor-tant part of most of the successful export promotion packages in other coun-tries. There are several different ways in which such access could beachieved; administrative aspects are important in designing the system sothat exporters can really get what is promised. One possibility would be togive exporters CEDIs for import duties actually paid. Alternatively, CEDIsgiven to all exporters of manufactures could include the average cost ofimport duties (averaged over the manufacturing sector as a whole). This wouldsimplify administration even more, and the small bias it would create againstusing a lot of imports in exports would not be harmful.

62. In the longer run, revision of the system of indirect taxation toincrease its efficiency and give systematic incentives for exports, as isdone in most European countries and many others, could be considered. Avalue added or one stage indirect tax based on the destination principle,so that all exports receive tax rebates as a matter of course, could replacethe cascaded sales tax which discourages division of labor through subcon-tracting and specialization.

63. Given the level and structure of protection, and the level of CEDIs,the level of the exchange rate needed to promote both exports and importsubstitution can be estimated, roughly, as a function of cost levels. Detailed,accurate and up-to-date information on cost structures were not available atthe time the mission visited Mexico, but the method can be illustrated withapproximate aggregate data. The latest month for which reasonably completeprice data are available is December 1976. The exchange rate for that monthwas 20.21 pesos per dollar; assume it is kept at the same real level throughsome target year, say, 1980. Further assume that protection and exportincentives are changed as suggested above, so that in 1980 protection againstimports of manufactures averages 10 percent of the official exchange rate,and that for exports of manufactures CEDIs are available at a face valueof 10 percent of exports, which is just about equal to the negative incentivesof sales tax on inputs (3.7%), sales tax on output (4%), and net protectionon inputs (2%, assuming that licensing is greatly liberalized and tariffs areadjusted as described earlier). 1/ Net export incentives would then be equalto the adjustment for the non-taxability of CEDIs (about 4%) and low-interestexport financing (assumed at the 1975 value of 2%), or a total of 6 percent.

64. This set of measures is shown in Text Table 4 and in Chart 1.1,under "1980 Case A." 2/ The real effective rate of exchange for imports of

1/ The percentages in parentheses are again in terms of equivalent before-tax sales revenue, as in Annex II, and can therefore be compared directlywith changes in the exchange rate.

2/ In Chart 1.1, the lines connecting the years are only to facilitatereading the chart; in fact the variables did not follow the straightlines shown. However, data to calculate all annual values are notavailable.

- 25 -

Text Table 4

Mexico: Alternative Exchange Rates, Protection

and Export Incentives

(in constant prices of December 1976)

19801970 1975 December Case A Case B

(December 1976 pesos per December 1976 dollar)

Exchange rate 18.99 18.00 20.21 20.21 22.23

Apparent protection for manufactures 18.8% 40.9% 25.5%-/ 10% 10%(in percent)

Apparent export incentives for manufac-tures (in percent) -12.0% 7.1% -9.3XS/ 6% 6%

Effective exchange rates for: aimports of manufactures b/ 22.56 25.36 25.36- 22.23 24.45

exportSof manufactures c/ 16.71 19.28 18.33fJ 21.42 23.56

Ratio of effective rate for imports toeffective rate for exports 1.35 1.32 1.38 1.04 1.04

Overvaluation (in percent) 2.8% 18.4% 5.4% 6.7% 8.0%

FTE exchange rate d/ 19.52 21.31 21.31 21.31 24.00

Net protection for manufactures (in 15.6% 19.0% 19.0%a/ 4.3% 1.9apercent)

Net export incentives for manufactures -14.4% -9.5% -14.0% -/ 0.5% -1.8%(in percent)

a/ Apparent protection for December 1976 was approximated by applying changes in wholesaleprices in Mexico, relative to wholesale prices in the United States, to protection in1975.

b/ Effective exchange rates for imports are defined as the average ratio of prices ofimports to prices in the domestic market, and thus reflect average realized protection.

c/ Effective exchange rates for exports include the estimated effects of various incentivesand disincentives, all expressed in terms of how much sales prices would have to changeto have the same effects on profits after taxes. See Annex II.

d/ The estimates of the FTE exchange rates for 1970 and 1975 are explained in AnnexII. For 1976 and 1980 Case A the estimates assume that the nominal FTEexchange ratewould change exactly in proportion to price changes in Mexico relative to price changesin the United States from a 1975 base -- i.e. that the constant-price rate would staythe same. However, the estimate for 1980 Case B assumes faster growth than the 1970-76period or than Case A. Thus the FTE exchange rate for 1980 Case B is estimated to be s-what higher than for the earlier years or for 1980 Case A. The actual FTE exchangerate for 1980 would depend on the actual other policies in effect and on the structureof the economy at that time.

e/ CEDIs, not in effect in December 1076. arp nnt i- elx,AaA. T-e4r restoration In

in April 1977, plus the movement of the exchange rate to 22.40 per dollar ( arproxisite-ly the same changes a5 in Mexican prices during January-March 1977), reduce netexport disincentives to close to zero.

- 26 -

manufactures, including protection, would fall 12 percent from its 1975 level,while that for exports of manufactures would rise 17 percent. Since theprojected exchange rate is estimated to be slightly overvalued, net protectionfor manufactures would be 4.3 percent and net export incentives for manufactur-ing would be 0.5 percent.

65. This set of policies would go a long way toward achieving the goalsset. The effective exchange rates for imports and for exports would be closeto each other, thus making production for export almost as profitable as pro-duction for domestic markets. Export profitability would be much higher thanin 1975; by a rough estimate it would be close to what it was in 1971 or 1972when CEDIs were first made available, before Mexican price rises offset muchof their good effects. The effective exchange rates for imports and forexports are very close to the projected free trade equilibrium exchange rate,which indicates that they are consistent with past growth levels. To expandoutput and employment even more, however, the package for 1980 might includean exchange rate higher than is assumed in Case A.

66. As an alternative to Case A, assume an official exchange rate 10percent higher in 1980 -- 22.23 pesos per dollar, in terms of December 1976prices. (That is, the actual exchange rate in the target year would be 22.23pesos per dollar, multiplied by a coefficient reflecting price increases inMexico relative to her principal trading partners, since December 1976.)With apparent protection and export subsidies as they were in Case A, bothimport substitution and export promotion are more strongly supported than inCase A. (See "Case B" in Text Table 4 and Chart 1.1.) In Case B, the realeffective exchange rate for imports of manufactures is only 4 percent belowthe 1975 level. Protection for domestic production for the domestic marketwould thus be maintained on the average, but with fewer instances of very highprotection. Manufactured exports, on the other hand, would be highly profit-able -- even more so than they were in the early 1970's.

67. Case B policies would induce faster growth than would those ofCase A, but would be slightly more inflationary. Compared to Case A, Case Bwould imply a slightly higher one-shot cost push stemming from the higher costof some imports (and those protected domestic substitutes sold under non-competitive conditions), and from demand-pull factors stemming from higherprices on export goods and higher employment generally. Of course, undereither Case A or Case B, eliminating the import licensing system would forcecompensating price reductions for products now enjoying very high protection.In the long run, increased employment and growth in the Mexican economy arehighly desirable and their negative effects in terms of inflation can be dealtwith by fiscal and monetary policies as well as more specific programs toincrease supplies of scarce inputs, whatever they may be. Thus Case B may bebetter than Case A for the long run. But right now, faced with an unusuallygreat need for an anti-inflationary policy, Case A may be preferable untilprice increases are more firmly under control. The choice between the twopolicies may, therefore, be essentially a question of timing.

- 27 -

68. Transitional Measures: The measures just outlined in paragraphs48-63 would represent considerable changes from the environment to whichmost Mexican manufacturing firms are accustomed. The evidence stronglysuggests that most firms could make the transition succesfully: the exportsthat Mexican manufacturers have already achieved, the moderate to low actualdifferentials between Mexican and international prices for most Mexicanmanufactured products, the analysis mentioned in paragraph 37 that concludesthat in most cases where protection in Mexico is sheltering high costs, thosecosts could be lowered if.necessary, and the fact that average peso costs ofimported manufactures would not fall significantly under the measures described.Nevertheless, care would be required to minimize both economic and psychologicalproblems of a transition.

69. The sequence of policy changes could be planned so as to start withmeasures that generally increase profits and export possibilities, and thento follow with reductions in protection. This is in fact what the Mexicangovernment has done in the last few months, allowing the exchange rate tomove to a more realistic level and restoring CEDIs.

70. Since Mexico has lived with the import licensing system for so long,it probably could not simply be abandoned all at once. The number of productssubject to licensing could be reduced over a period of a few years, perhapsstarting with intermediate goods and capital goods. Alternatively, or comple-mentarily, temporary higher tariffs could be applied to high-cost products asthey are decontrolled, to give producers of each product a reasonable timeto reduce costs. The desired results of this program would not be achieved,however, unless any tariff increases are clearly specified as temporary only,and are reduced over a reasonable time specified in advance.

71. Pending complete elimination of import controls, the governmentmight consider granting automatic permission to import any item regardlessof its tariff, on which the importer was willing to pay a fixed high tariff(say, 50 percent). This would place a ceiling on the amount of total pro-tection from the combined effects of import permits and tariffs. Also, ex-porters could be automatically granted licenses to import inputs, with sub-sequent periodic checks to insure re-export of the goods.

72. Making credit and technical assistance available for re-equipment,training, or reorganization of firms which would be forced to lower costsand/or improve quality in order to survive would also help to ease thetransition. Insuring availability of working capital, and a possible expandedrole for government trust funds, as discussed below in paragraphs 116-122,would be of help here.

73. Assistance to displaced workers would be important. Mexico has nounemployment insurance and few other programs to help workers find new jobs.In this situation the authorities are understandably reluctant to permit firmsto fail, even if the firms are inefficient, because the displaced workerscould be badly hurt even though the economy as a whole would benefit. Provid-ing better assistance to displaced workers is therefore desirable for tworeasons: it would reduce political pressure to protect inefficient firms,

- 28 -

and it would spread the cost of achieving greater efficiency over the societyas a whole, where it belongs, rather than concentrating it on workers in theindustry involved.

Conclusions: Foreign Trade Policies

74. In conclusion, the mission's analysis suggests that:

(i) An exchange rate around 20-22 pesos per dollar, in termsof December 1976 prices, plus restored CEDIs and a greatliberalization or dismantling of the import licensingsystem, would promote rapid growth of employment and effi-cient production in Mexican manufacturing. This set ofpolicies would promote both efficient exports and efficientimport substitution, with not only growth in output andemployment but also improvements in quality of Mexicangoods.

(ii) Promoting exports and import substitution mainly throughthe exchange rate, instead of through special protection orpromotional schemes, will call forth growth in sectors whereMexico is most efficient--including tourism and efficientagriculture and mining, as well as manufacturiag. This willincrease use of Mexico's abundant labor force, and reduceor remove instances of very high cost or low quality importsubstitution. Such a strategy will make export profitscloser to profits on domestic sales of a given product,and induce more specialization and scale economies, ratherthan the more diversified and less efficient productiondesigned only for a captive domestic market now common inMexican manufacturing. Mexico's manufacturing sector isnow mature and developed enough to benefit from such asystem, without suffering large-scale replacement ofdomestic production by imports.

(iii) Promoting growth through stable rules, known in advance andapplied automatically, instead of relying on many dailydecisions about granting import permits, CEDIs, etc.,will permit entrepreneurs to estimate their costs andprofits with more assurance. Investment, for both exportsand domestic sales, will be on more economical scales ofproduction and more concentrated in sectors where it ismost profitable.

- 29 -

II. Public and Foreign-Owned Enterprises

75. As in most other less developed countries, public, domestic private,and foreign-owned enterprises coexist in Mexico. Similarly to the situationin other countries they are each concentrated in different industries, theyare ruled by c`'ferent laws and they show different economic performance.

Public Sector Enterprises

76. Magnitude: The public sector in industry increased rapidly duringthe last five years or so. Public investment in manufacturing is estimated tohave been 57 percent of total investment in the sector during 1971-75. Theimpact of public investment in industry was strikingly unequally distributedover time; in 1971 the public sector was responsible for only 20 percent oftotal industrial investment; during 1974 and 1975 the percentage had increasedto as much as 80 percent while private investment in industry had declined toan insignificant level.

77. As of 1976 there were some 400 enterprises in which the publicsector held a majority interest in the economy as a whole, of which only 15account for about 90 percent of total investment. In the manufacturingsector, of 34 large public sector enterprises only five 1/ have fixed assetsabove $100 million; these five account, together, for 88 percent of the totalfixed assets of the group of 34. These enterprises increased their assets by$1.7 billion from 1973 to 1975 -- an increase of 140 percent. To finance thisexpansion they increased their indebtedness by $1.4 billion, which impliesthat 80 percent of the increase in their assets was financed by loans. Capitalfor the substantial sample of enterprises was distributed principally amongfive industries: sugar (5 percent), automobiles (22 percent), machinery(2 percent), chemicals (13 percent), and steel (58 percent). However, thepublic sector is also involved in smaller enterprises throughout the manufac-turing sector, from bakeries to bicycles.

78. Motivation: The Mexican Government invested substantial resourcesinto a few key sectors of the economy mainly to control prices and/or toassure domestic development of the industry. Both reasons were important insteel and petrochemicals, where investments are large, lumpy and have longgestation periods; the price element is very important because the prices ofthese products play important roles in determining the price level of manyother industrial goods in the country. The government entry into the auto-mobile industry is somewhat more difficult to explain, the motivation appar-ently being a desire to put up a national counterpart to foreign investmentso as to have more leverage in pressing for decreasing the import content ofautomobile production, as well as to see this production located in an areawhich the Government wanted specifically to develop. In sugar it has been,in turn, the Government's desire to resolve a long standing conflict between

1/ Sicartsa (steel), Guanomex (fertilizer), Altos Hornos (steel), DieselNacional (motor vehicles), and Constructora Nacional (railroad equip-ment).

- 30 -

the refiners and the cane growers in favor of the latter -- with the result-ing income distribution effect -- and its simultaneous resolve to maintain alow consumer price.

79. Performance: Because a large share of the Government's involve-ment in manufacturing is of very recent vintage, only a part has become fullyproductive and it is still too early for a full review of its efficiency.However, when important enterprises which did not go on stream before late1976 (e.g., SICARTSA) are excluded, one could reasonably expect to see theinvestment performance of the remaining enterprises improve over time. Thisdoes not seem to have been the case. The mission has collected and analyzedthe balance sheets and profit and loss accounts of over 30 industrial enter-prises with either exclusive or predominant public participation. This sam-ple was broken down into five large groups: sugar industries, which included17 enterprises, steel with 3 enterprises, automobiles with 3 enterprises,machinery and appliances with 6 enterprises, and chemicals consisting of 2public enterprises. While the assets of these enterprises have doubled overthe last three years, their cumulative losses increased by 70 percent. Theirindebtedness increased sharply, with their debt-equity ratio growing from 1.9in 1973 to 3.2 in 1975. Losses on production were incurred in practicallyall industries except for steel, where Altos Hornos retained an earningcapacity, and for chemical industries, where Guanomex remained profitable. By1975 the ratio of losses to net worth became 4.3 percent, an increase from 3.3percent in 1973 and 2.6 percent in 1974. (See Table 1.5 for more details.)

80. Part of the cause of this poor performance lay in the division ofauthority over and lack of control of these enterprises. Responsible intheory to the Secretariat of National Property, with investment plans clearedby the Secretariat of the Presidency, and with the Secretariat of Financepaying the bills for whatever deficits appeared, the enterprises did not havestrong incentives to hold down costs or to keep prices in step with whatevercost increases did occur.

81. The current government has shown its recognition of these problems,in enacting two laws which may help to remedy the situation (Ley de la Admin-istracion Publica and Ley de la Deuda Publica). Responsibility for the plan-ning of public investment and other expenditure programs, the budgeting ofcurrent expenditures, and the planning and control over state enterprises'expenditure has all been placed in the new Secretariat of Programming andBudgeting. Alter approval by that Secretariat, state enterprises must submitto the Secretariat of Finance their plans for expenditures, a schedule of thesources of funds to cover the expenditures, and where borrowing is plannedthey must specify sources of funds to cover future debt service. Moreover,the approval of the Secretariat of Finance is required before even preliminaryexploration of new foreign borrowing may take place. These new statutesimprove the government's ability to control capital expenditures and indebted-ness of state enterprises, and it is to be hoped that they will prove usefulin this regard.

- 31 -

82. Pricing: The pricing system is an important element in determiningthe financial performance of public enterprises. Comparison between domes-tic and international prices is a reasonably good indicator of efficiency ofdomestic production. Such comparison should, however, also take into accountwhether, at the present level of domestic prices, the enterprises are gener-ating any profit, and whether the exchange rate is close t, an equilibriumlevel.

83. In steel, price ceilings have been imposed since 1956. The privatesector has complained frequently that these ceilings were too low and thatthey were limniting its capacity to generate internal resources. However,there is little evidence that price ceilings, at least those prevailing inthe 1960s, were any lower in Mexico that prices prevailing within the mainsteel-producing countries. At 12.5 pesos per dollar, price comparisons be-tween Mexico and other countries show that Mexican prices were roughly atthe level of international prices at that time. This should be viewedagainst the backdrop of the public steel industry still generating some netprofits -- the return on net worth in operating enterprises in the steelindustry in 1975 was 4 percent, compared with 6 percent in 1973. With arate of 20 pesos per dollar and a less-than-proportionate domestic priceincrease, Mexican steel prices became about 20 percent lower than inter-national prices.

84. Sugar prices had been kept unchanged since 1970, while the pricepaid to cane growers increased by 190 percent. Thus by mid-1976 the costof cane to the sugar refiners became, at 2.15 pesos per kilogram, equal tothe price of refined sugar charged by commercial enterprises for distributionto consumers. As a result, private owners of refineries could not operatetheir factories profitably; the government has taken over some factories anddecided to set up a few new ones, to be operated by government corporations,so as to increase production capacity by about 460,000 tons of sugar a year.At 2.15 pesos per kilogram (about 8 U.S. cents per pound before August 1976),sugar was considerably cheaper in Mexico than in international markets, evenat presently depressed prices in the latter. Low prices to the consumer werepartly compensated by higher prices (about 13 U.S. cents per pound) to indus-trial users, but the government had to carry the brunt of the subsidization.Consumer prices for refined sugar have been increased to 6 pesos per kilo (14U.S. cents per pound) in the last week of December 1976; this price is prac-tically at par with the price paid to industrial users, and compares favorablywith current international prices of about 8 to 10 U.S. cents per pound.However, the price of brown sugar is still set at the 2.15 peso level, whichhas resulted in its virtual disappearance from the market.

85. In fertilizers the government granted GUANOMEX, a wholly ownedgovernment corporation since 1965, sole responsibility for marketing fertil-izers in order to avoid excessive price fluctuation and prevent the saleof fertilizer to final users at what has been considered to be a high price,mainly attributed to unreasonably high profits of intermediaries. Comparisonwith international prices shows that at least in the case of some fertilizerproducts there might have been a strong subsidy. Thus in 1975 even at the

- 32 -

exchange rate of 12.5 pesos per dollar, Mexican prices were in most casesbelow the U.S. prices. When the peso began to float, even after some domesticprice adjustment Mexican prices were 11 percent below U.S. export prices.

86. In the automotive sector, most firms are private. Government setsprice ceilings which have been roughly 50 percent above international levels,at the past exchange rate of 12.50 pesos per dollar. These price levels seemto be sufficient for most companies to earn satisfactory returns, but thepublic sector firm has been suffering losses.

87. Text Table 5 summarizes price policy An public sector enterprises inthe important sectors just discussed.

Text Table 5Mexico: Prices and Profits in Public Sector Manufacturing Enterprises

Sector Prices Profits

Steel (excluding Equal to or Low butSicartsa) below imports positive

Sugar Low until NegativeDecember 1976

Fertilizers Low Positive;diminishing

Automobiles Above imports Negative

88. The government desire to hold down prices in steel, sugar, somechemicals, and fertilizers may by itself have been one of the major causesof unwillingness of the private sector to invest in these fields. These lowprices are maintained in order to transfer resources to private users of theproducts. However, it is not clear how much such measures increase socialjustice--the subsidized fertilizer is used mostly on large highly profitableirrigated farms, for example. The policy seems even more questionable whenits results in terms of higher public sector deficits, higher inflation, anderosion of purchasing power are also taken into account.

89. Pricing policy in public sector enterprises involves more than justraising prices to cover costs. Such action helps to reduce the overallpublic sector deficit and to bring relative prices more in line with produc-tion costs of different products. But it does little to discipline theenterprises to control their costs. Cost control, including economic cal-culations on new investments and their returns, would be improved if public

- 33 -

sector enterprises were required to cover a predetermined portion of theiroperating costs and investment requirements from operating revenues. Sucha requirement cannot be applied 100 percent to all public enterprisess--forexample, it would reduce the effectiveness of Conasupo, whose objective isto supply basic foods at low prices. The requirement could, however, beapplied to most or all public sector manufacturing enterprises, with thepercent of costs that must be covered set below 100 percent where appropriate.A requirement to cover even part of expenses would increase incentives forefficiency.

90. Purchases of equipment: Another important aspect of the role ofpublic enterprises in industry is their reluctance to use domestically producedcapital equipment. Until now the public sector in Mexico has been supplyingits large and growing requirements for capital goods mainly from imports. Thestrong proimport orientation of the public sector is due to three factors:

91. First, public sector enterprises, while planning for future expan-sions and related capital requirements, were unable to predict the resourcesavailable to them from the Treasury, and were similarly unsure of Treasuryapproval for future foreign borrowing. Consequently, the public enterprisescould not negotiate long-term contracts with potential domestic suppliers ofcapital goods. Such contracts could have helped private domestic enterprisesto prepare designs and technology well ahead of time and, after those wereapproved, to supply more equipment in required quality and within reasonablecosts. The absence of such arrangements contributed to a situation when, eachtime the public enterprises realized that their financing capacity -- largelydepending on Government decisions -- permitted them to purchase capital equip-ment, foreign suppliers proved to be more flexible in providing appropriateterms of delivery and quality of required goods because of their accumulatedexperience, while domestic suppliers were handicapped in this respect.

92. This situation changed somewhat recently with the creation of Com-isiones Mixtas de Abastecimientos, supposed to enquire not only into whatthe domestic industry currently produces but also into what it could produce.The positive result was best shown in purchases of goods from domestic indus-try by the Comision Federal de Electricidad. The CFE was purchasing as muchas 63 percent of its supplies from foreign sources in 1973; by 1976 importsfell to only 39 percent. However, the CFE's long-term plan for 1978-1990still foresees that out of the projected $8 billion purchases of plant andequipment, as much as 75 percent will be purchased abroad -- unless thedomestic industry sets up new capacities or organizes its existing capacityso as to be able to supply the required equipment.

93. The second reason for the preference given by public enterprisesto imported capital goods lies in high prices of domestically producedcapital goods. The price differential can be quite large in some cases;domestic goods costing 80 percent more than imports (at the pre-devaluationexchange rate) are reported. To a certain extent, this situation is of a

- 34 -

classical vicious circle type, because the relatively high price level is inpart attributable to the still relatively small scale of production of theprivate sector enterprises. Had they been given a full possibility to sell tothe public sector, this disadvantage would no doubt diminish. Thus, in 1975total Mexican imports of capital goods amounted to $2.4 billion of which over$1.2 billion were purchased by the public sector. In the same year, thegross value of production of domestic capital goods producing industriesamounted to some $1.1 billion. There is little doubt that the latter couldhave produced some of the imported goods and that such addition to theirproduction would have permitted them to reduce costs and prices. Anotherdimension of the same problem is credit terms, which are far more generous inthe case of imported equipment than for that produced in Mexico. The over-valued exchange rate also made imports relatively cheaper.

94. Third, public enterprises are entitled to import without having topay any customs duties. They are supposed to allow domestic producers amargin of 15 percent over import prices, but since the 15 percent is only anelement in a calculation and never has to be paid in the case of imports, itprovides less motivation for purchasing from domestic producers than would anactual tariff of the same amount.

95. To what extent the introduction of the new exchange rate, even ifcoupled with elimination of tariff exemptions and/or moderately higher tariffrates on capital goods, could equalize the chances of domestic manufacturingin bidding against imports for public sector orders is still unknown. It isalso somewhat puzzling that the accords, negotiated late in 1976 between theprivate sector and the then Director General of IEPES do not include commit-ments as to the approximate extent of public purchases from private manufac-turers. The accords involve some $8 billion in private investment by 170firms in 10 sectors over the next six years. Each agreement includes prom-ises from the private sector (usually investment and/or production goals),a quid pro quo from the public sector (usually unspecified promotion and/orincentive measures) and statements of joint action (usually joint groups orcommittees to study promotion problems and needs). These accords are im-portant instruments to restore confidence in a fruitful cooperation betweenthe public sector and private industry. They should be considered, however,only as a first step, and their effectiveness may gradually wane if they arenot followed by a change of industrial policies including specific inten-tions and, later, contracts of public sector enterprises for purchasinggoods which private industry would be able to supply.

96. Conclusions: Three basic conclusions can be drawn from the analysisof the situation in the public sector:

(i) Large amounts of private capital actually invested in steel,automobiles, sugar, and chemicals suggest that if the privatesector had adequate access to credit in pesos (see paras. 113-116), freedom to set prices at a reasonably remunerative level,and perceived a more favorable investment climate, then private

- 35 -

entrepreneurs might have continued to put their resources inthe sectors where public investment has been large, alongsideor even instead of public resources. The Government nowappears more disposed to consider possibilities of eitherjoint ventures with the private sector or, in cases where theprivate sector proves to be willing to invest enouf of itscapital, even to shift allocation of its resources to othersectors of the economy. In the latter case, public goals suchas pricing, location, or domestic integration could be equallywell achieved through the use of appropriate economic policies,some of which are discussed in this report, as through directdecisions of managers of public enterprises.

(ii) If prices of goods produced by public sector enterprisescovered production costs, returns on capital invested inthe public sector could become sufficient to pay for asubstantial share of new investment from internallygenerated resources. Indeed, imposing a requirementfor at least partial self-financing of investment couldhelp to induce a more appropriate pricing policy, as wellas draw more attention to a need for cost reductions. Tothe extent to which, through a more flexible price policyand more exacting performance criteria the public enterpriseswould be able to finance a larger part of their expansion,the danger that capital allocation from the budget may notbe forthcoming during years of budgetary squeeze would be-come less than it has been hitherto.

(iii) The public sector could promote domestic production ofequipment, at little cost to itself or the nation, if long-term planning of capital expansion became an explicit dutyof public enterprises. The projections of physical expansionand resulting needs for equipment are often available, but thefinancing of the expansion and hence the actual purchase ofequipment are left open. To make such plans more specific,more realistic, and thus more useful, the proportions of theirown financing and of budgetary allocations should be set forthwell in advance. In turn, if their expansion plans were madepublic, with detailed specifications of equipment requirements,the domestic equipment suppliers could prepare longer-termproduction plans and probably could supply a greater share ofpublicly purchased equipment, within acceptable quality normsand price, than they have been able to do in the past. Evenwhere foreign financing and international tendering isinvolved, advance information of the specifics of thefuture demand may somewhat equalize the chances ofdomestic firms in competing with other, more experiencedbidders.

- 36 -

Foreign-Owned Enterprises

97. lIagnitude: Foreign-owned enterprises account for a substantialshare of investment in Mexico. During the years 1972-75 tt'a1 r -.

investment represented 5 percent of total economy-wide private investment inMexico. Seventy-two percent of total foreign investment came from the UnitedStates, 6 percent from the Federal Republic of Germany, and 5 percent from theUnited Kingdom, with various countries sharing the remainder. Some 4,100enterprises in Mexico have some foreign participation, and in almost two-thirdsof these enterprises the foreign participation exceeds 50 percent.

98. About one-half of these enterprises and three-fourths of the totalamount of foreign capital were located in the manufacturing sector. Thisshare has changed but little over time, growing from 74 percent of the totalin 1970 to 75 percent in the total in 1975. Of the total of some $1.2 bil-lion invested in enterprises with private foreign participation during1972-75, $930 million went into manufacturing. This amount is, roughly,about 25 percent of total new investment in manufacturing. 1/ The share ofpublic investment is estimated at 57 percent, so the residual of 18 percentrepresents investment undertaken by private capital without public or foreignaffiliations. Thus foreign private investment is quite important just forthe amount of investment it represents, apart from other aspects. (See Table1.6 for more details.)

99. The importance of foreign private investment can be partly ex-plained by its greater access to financing (even in cases of only partlyforeign-owned firms), from parent companies or other linked foreign sources.Foreign liabilities of Mexican enterprises in which foreign participationexceeded 5 percent (manufacturing enterprises represented 67 percent of thisstatistical universe) grew by almost $600 million in one year: from $3.2 bil-lion in 1974 to $3.8 billion in 1975. Of this amount 17 percent was obtaineddirectly from the parent companies abroad, and a substantial part of the bal-ance came from financing sources related to these parent companies.

100. Thirty-five percent of the foreign financed investment in manufactur-ing went to the machinery and transnort equipment industry, compared to only13 percent of the total channeled i-ito this sector by all investors combined.The chemical industry was another large beneficiary, accounting for 26 per-cent of the total private foreign industrial investment, compared to only17 percent of the total for all investors combined. Thus foreign investmentis particularly important in sectors with complicated technology.

101. Export performance: It has been a long-standing belief that for-eign investment in developing countries is bound by restrictive claus. s, im-posed by parent companies, to restrict exp.Jrts so as to avoid infringing

1/ Based on approximate estimates by tne niission of total investment inmanufacturing.

- 37 -

upon the parent companies' markets in other countries. The extent to whichthis practice was followed in Mexico is unknown, but since 1973 the practicehas been forbidden by Mexican law. The automobile industry, in which foreigninvestment participated substantially, 1/ has proven to be one of the mostdynamic exporters of manufactured products, with a total value of exports of

about $150 mi1lior, in 1974 (see paragraph 27).

102. An ECLA study, using data from an IMCE sample survey, reports thatin 1975 multinational corporations accounted for 55 percent of Mexico'smanufactured exports (ECLA, 1976, page 80). Industries where these foreignenterprises were reported to be most important were petroleum products,transport equipment, chemicals, machinery, rubber, electrical equipment, andthe miscellaneous category, in all of which multinationals accounted formore than three-quarters of all exports. The mission's estimate of the shareof manufactured exports coming from firms with foreign participation is 37percent, rather lower than the ECLA estimate. Nevertheless, both estimatessuggest that foreign investment is important for manufactured exports.

103. A review of foreign private investment in Mexico carried out byStanford Research Institute in late 1975 shows that gross sales of manufac-turing enterprises with foreign participation amounted to $4.2 billion in1974, compared to $26 billion of total industrial sales in this year or toabout 16 percent of total sales of industrial goods. In the same year theseforeign-owned enterprises exported industrial goods worth some $250 million,equal to 6 percent of their output, while the manufacturing sector as a wholeexported only 5 percent of its output (both figures exclude assembly plants).The share of particularly difficult exports like those of the engineeringindustries is much higher for enterprises with foreign participation thanfor the others. Thus, for instance, as much as 63 percent of total exportsof electrical machinery originated in enterprises with foreign participation.

104. Foreign private investment can facilitate cooperation with multi-national enterprises in other countries. The best example here would beBrazil, which is included in ALALC and therefore has easy access to the Mex-ican market. Exports of Brazil to Mexico have been increasing at 46.5 per-cent per annum, during 1972-75, compared with the overall increase in Mexicanimports of 34 percent per annum (all in current terms). The total stock offoreign direct investment in Brazil ($7 billion in 1972, of which 70 percentis in manufacturing) is much larger than that in Mexico ($3.6 billion, ofwhich 77 percent was in manufacturing--also for 1972), and as much as 41percent of total imports by Mexico from Argentina and 35 percent of totalimports from Brazil consisted of goods produced by foreign-owned enterprises(Fajnzylber and Martinez, 1976). This trade should be viewed as an importantpart of a continent-wide specialization of ALALC countries, in which foreignenterprises play a substantial role -- as they did at the onset of the Euro-pean Common Market specialization.

1/ Out of 14 automotive plants, 5, including tractor plants, had a 100percent foreign ownership, 2 firms had a substantial foreign participa-tion, 2 firms had a 100 percent government ownership, and the remain-ing 5 firms, mainly producing tractors, trailers and buses, had a 100percent private Mexican capital.

- 38 -

105. Regulation: New foreign investment legislation introduced in Mexicoin early 1973 consists of the Law on Promotion of Mexican Investment andRegulation of Foreign Investment, and the Law on Technological Transfer andUse and Exploitation of Trademarks and Patent Rights. The former introducesthe general rule of 49 percent foreign capital ownership of manufacturingenterprises as a maximum. This is considered as the most important regulationin this field. It appeared to have created some uncertainty among foreigninvestors who had become used to the idea that companies could be set up inMexico with 100 percent foreign capital and still be considered nationalcompanies. Prior to this law, although restrictions had been imposed oncertain fields of activity for companies with foreign capital majority,joint ventures were in the minority. Even stricter limits than this nowgeneralized rule of 49 percent foreign capital exist in certain fields suchas mining (34 percent) and manufacture of automotive parts (40 percent).However, the National Commission of Foreign Investment established by thislaw is empowered to authorize increases or decreases of foreign capital par-ticipation, and on occasion has authorized creation of companies with 100percent foreign capital as exceptions, without stating any general criteria.

106. The law is not retroactive and therefore does not change the legalsituation of the foreign investment which existed before it went into effect,although it applies to their expansion, which tends to create some compli-cations. In the period since the law has entered into operation, untilApril 1976, about 345 enterprises with foreign participation were establishedin Mexico and the inflow of foreign private investment in manufacturingapparently has not decreased. Of these 345 enterprises, foreign participationin 338 has not exceeded 49 percent. Most of these enterprises were small;only 28 of the 345 had capital exceeding $800,000.

107. In the technological transfers and trademarks and patent law, theroyalty section presents the greatest interest, because it introduces a clas-sification which should protect users of foreign technology from beingcharged more than competitors in the same sector. Also, payment for trade-marks is limited to 1 percent on net sales. Another important prescriptionis that all foreign trademarks should be used together with their domesticacronyms. 1/ The licensee acquires rights to improve on or develop his owntechnology in addition to the acquired one. Finally, almost all restrictionson exports of manufactured products which incorporate foreign technology wereruled out.

108. To seek benefits from the existing system of fiscal incentives inMexico, the foreign investor must not only conform to the 49 percent partici-pation rule but as another condition, his entire transfer payment for foreigntechnological assistance and use of trademarks should not exceed 3 percentof net annual sales.

1/ The importance of foreign trademarks is considerable; of about 6,000foreign contracts signed within the last few years, 2,900 included theuse of trademarks.

- 39 -

109. Conclusions: The mission's analysis of foreign investment suggestsfive general conclusions:

(i) Regulation. There is little doubt that a developing countrycould only benefit from foreign investment legislation thatis designed, on the one hand, to help the countr, to derivefrom this investment the greatest possible advantage for itsnational economy and, on the other, attract as much aspossible, serious foreign investors. However, undue com-plexity of the law or limitation of foreign entrepreneurs'freedom to decide on their product mix or expansion plansquickly and on their own, has sometimes led, in othercountries, to a slowdown in the inflow of foreign investment.It has also been proven elsewhere that instead of veryspecific measures, across-the-board industrial policieswhich apply to the entire manufacturing sector withoutmaking a distinction between public, domestic private andforeign private enterprises, can be so designed as toextract the largest benefit possible for the economy fromeach of these groups.

(ii) Industrial strategy exceptions. Exceptions from the 49-51participation rule are not made clear in the law and wereleft to the discretion of officials of the Secretariat ofIndustry and Commerce. Large established firms may knowhow to deal with the bureaucracy, and large new potentialinvestors can afford to hire advisors who know this. Butthe need to negotiate and the uncertainty of the outcomemay constitute barriers to entry, especially for smallerfirms. Therefore, while flexibility can be useful, the lackof clear and explicit rules of the game may deter some newinvestors. Clear stipulations as to specific areas ofnational interest where exemptions could be made to permitmajority participation of foreign capital might be useful(e.g., enterprises located in undeveloped regions; export-oriented industries where foreign investors may have betterknowledge of or access to foreign markets; producers ofcomplex products, such as engineering industries which appearparticularly attractive to foreign investors and in whichthey enjoy the advantage of the research and developmentresults of their parent companies).

(iii) Financing. In a situation where credit is scarce it mayprove difficult for domestic entrepreneurs to financethe 51 percent or more of capital in enterprises whichforeign investors want to set up or to expand. Moreover,foreign investors seem to be willing to invest in industriesthat domestic investors are sometimes not very interestedin. (Capital goods is an outstanding example in Mexico.)

- 40 -

For both these reasons if the 49-51 percent participationrule remains as the strict letter of the law, some valuableinvestments may not materialize for the lack of domesticcounterpart investors. It may be advisable to consider somespecific provision in the law, designed to avoid losing oppor-tunities in this way.

(iv) Quality. The law of trademarks may impede those foreigninvestors who identify their own trademarks with a highquality of product and who would like to remain responsi-ble for the quality of the product. One way to avoid thisproblem could be a clause in the contrfact permitting theforeign investor to forbid use of his trademark some timeafter he withdraws from the enterprise, if he can provethat the quality of production is deteriorating. Also, thelimitation of transfers of royalties and making fiscalincentives conditional upon their amount may deprive Mexicoof the benefits of some technology that might be worthconsiderably more than its cost in royalties. These provi-sions should be reviewed with special care in cases ofindustries where exports are potentially important, or whereresearch and development is particularly costly.

(v) Joint ventures. The last and probably the most importantpoint is that of the tripartite agreements between foreigninvestors, private domestic investors and public investorsto set up joint ventures, in which the Mexican authoritieshave shown considerable interest. This type of agreementhas been tested in some other semi-industrialized countriesand has proven to provide substantial benefits to the coun-try. Foreign investors contribute their managerial experi-ence and technological achievements, domestic private inves-tors their knowledge of the country's internal market, ofits manpower, and of the financial and legal complexities,while the public participation was usually considered aguarantor of the country's interests in the project, andalso helps to navigate the country's regulations and admin-istrative procedures. Experience of other countries hasshown that the presence of a strong negotiator, such as oneof the local development banks considered as being bothcompetent and impartial by all interested parties, is oftenimportant to the success of such ventures.

- 41 -

III. Industrial Financing

110. The inflation and lack of confidence of the last few years have haddrastic effects on Mexico's well-developed financial sector, and on the creditsituation faci-g Mexican industry. Savings have been directed away fromMlexican financial intermediaries and into foreign assets and cash. The issuesfor policy are how to restore the flows of domestic savings, maintain accessto foreign credits, and provide an institutional framework in which theseresources will be allocated to productive uses. Ensuring adequate domesticsupplies of credit may be even more important than it was earlier becauseMexican business firms may now be more reluctant to_borrow abroad than theywere before the recent devaluations. The main direct instruments availableare the exchange rate, the yields on both financial and real assets, and thegovernment's fiscal management (or more precisely, reduction of the publicsector deficit).

The Financial Situation

1ll. The Mexican economy has a relatively well developed financial sys-tem. This development has taken place almost entirely through the growth ofthe banking system, consisting of public, private, and mixed enterprises inboth commercial banking and development banking. Direct financing of firmsthrough the public issue of stocks and bonds is much less important. In theyears leading up to 1973, the resources available to the banking system grewsubstantially faster than GDP and allowed credit to the private sector togrow about twice as fast as GDP.

112. Non-monetary deposits made up more than half of the financialsystem's liabilities, and amounted to 27 percent of GDP in 1973. Theseshares are typical of developed countries and of developing countries withrelatively well-developed financial systems (see Table 1.7). This achievementwas made possible by economic stability, a positive interest rate differen-tial with respect to foreign interest rates (spreads of 2 to 5 percentagepoints during the last ten years) accompanied by full convertibility of thepeso, and until 1972 a positive real interest rate in the domestic market(see Table 1.8). However, a large portion of those non-monetary depositswere held in very short-term instruments, the longest being a one-yearpromissory note; about one third of the value of the deposits was completelyliquid.

113. The liquidity of the liabilities of the banking system, whichwas of course one reason why -they were attractive to savers, also made thesystem highly vulnerable. In 1973 and 1974 non-monetary deposits fell inreal terms, as real interest rates turned negative and the interest ratedifferential between foreign and domestic rates was reversed. Rising ihflationrelative to M4exico's trading partners induced devaluationary expectations,thereby further reducing the incentive to invest in peso-dominated financial

- 42 -

assets. This trend was reversed in 1975, due to the decline of inflationaryand devaluationary expectations and the fall in interest rates prevailing ininternational markets. However, resumption of speculation against the pesoearly in 1976 coupled with the effects of the subsequent devaluations areestimated to have caused non-monetary peso deposits to drop by almost30 percent in real terms in 1976. Increases in the money supply and theincrease in externally financed credit (associated with the rapid increase inpublic sector external borrowing) acted as somewhat compensatory elements, buttotal credit still fell by an estimated 10 percent for the year. As aconsequence of the drop in intermediation, the real stock of domesticallyfinanced credit to the public and private sectors combined is estimated tohave been 12 percent less at the end of 1976 than at the end of 1972, whileGDP grew by an estimated 23 percent over the same period. (See Table 1.9,where these trends are shown in relation to GDP.)

114. Availability of domestic credit to the private sector was even moresqueezed because the public sector preempted part of the already scarce re-sources to help finance its rapidly increasing deficit, which is estimated tohave gone up from 4.5 percent of GDP in 1972 to 9 percent of GDP in 1976.As a consequence, the real stock of domestically financed credit to the pri-vate sector was 23 percent less at the end of 1976 than at the end of 1972and the private sector's share in total credit dropped from 50 percent in1970 to 35 percent in 1976. (See last two columns of Table 1.9.)

115. Thus credit to the private sector has been doubly restricted,first from the fall in mobilization of savings and second by the increasingshare of available credit being preempted by the public sector. Within theprivate sector, special credit programs helped maintain the share of agri-culture and livestock in the total, while industry's share has been eroded.(See Chart 1.2.)

116. The direct effects of the credit squeeze have been felt most onworking capital; financing for new investments or expansions of productioncapacity has been more readily available. However, the squeeze has affectednew capacity creation indirectly, as additional capacity also implies addi-tional working capital requirements. Some firms have been reluctant to investin new capacity, even if financing was available, because of present and/oranticipated future problems in financing working capital needs.

117. The negative effects of this credit squeeze on private industry'scash situation have been aggravated by recent cost increases. Some of theseincreases are due to the devaluation (interest on foreign borrowing, replace-ment and expansion costs of imported equipment, some current inputs) whileothers are not (electricity). Thus, during recent months many private busi-ness firms are facing a severe cash squeeze because their costs have risenmuch faster than their sales prices. These problems beset efficient firmsas well as inefficient ones. At the time of the mission's visit to Mexicoin October-November 1976, the Banco de Mexico was aware of this situationand was taking steps to assure that some credit would be available to help

- 43 -

firms through this period. Moreover, information obtained from the privatesector suggested that only a relatively small percentage of firms were inimmediate danger of bankruptcy. Nevertheless, the situation clearly deservescontinued attention and prompt action where necessary. Not only bankruptciesbut also lay-offs and reductions of scale of operations for lack )f workingcapital represent a wastage of Mlexico s resources. While restricting creditmay be a necessary part of a general anti-inflation program, care should betaken to make it felt in restriction of non-essential consumption and invest-ment, while providing access to working capital for ongoing enterprises.

118. Financial institutions themselves have been seriously affected, asincreases in their own administrative costs and interest payments have ex-ceeded growth in their income. Financial institutions have not been able topass on all these costs to borrowers through increased interest rates, in partbecause they were facing competition from dollar-denominated loans fromforeign banks (at least through 1975), and partly because increased reserverequirements have reduced the portion of their resources which the banks couldlend. Consequently the financial sector's rate of return on equity, andprofits expressed as a percent of average assets, have both declined -- eventhough the gross spread and debt-to-equity ratios have increased. (SeeTable 1.10.)

Finance: Conclusions

119. The recovery of financial intermediation in Mexico, perhaps alreadybegun in the first half of 1977, requires confidence above all. Thus itcan be achieved only in the context of a serious and comprehensive stabili-zation effort aimed at a gradual reduction in inflation, a gradual and sus-tained increase in public sector savings, and a reduction in the balance ofpayments deficit.

120. One key to achieving these goals is avoidance of another cycle ofovervaluation of the peso. This has already been dealt with at length inrelation to trade in goods and services; its importance for mobilizing financ-ial resources is obvious. Confidence in a stable nominal value of the pesois not absolutely necessary, although of course it is very desirable. Whatis necessary is confidence that a large devaluation will not occur again,combined with interest rates high enough to compensate for any expected smalldevaluations.

121. Another crucial ingredient to assist recovery of financial savingsand to make them available to Mexican intermediaries would be the provisionof a number of attractive alternatives for financial investments by bothMexican and foreign private savers. The essential characteristics of thestrategy would be to provide a full range of different types of instrumentsso as to attract the largest possible number of savers, and to permitinterest rates to go high enough to attract the amount of resources neededto finance both the government's and the private sector's needs.

- 44 -

122. An example of the new type of obligations just mentioned are the"Petrobonos" (bonds indexed to the price of petroleum) recently issued bythe government. A further possibility during the period of price stabiliza-tion in Mexico would be to permit banks to issue peso-denominated obligationsindexed to the exchange rate. Issuing such obligations with maturities ofone year or more would help to reduce the vulnerability of the Mexican financ-ial system by lengthening its term structure. If these obligations wereeasily transferrable, liquidity could be provided by a secondary market, whichwould also be a useful barometer of credit conditions. The possibility ofissuing government notes similar to US Treasury bills could also be explored.

123. The higher real interest rates paid to depositors would have to bepassed along to borrowers. In the present situation, this would tend to in-crease the role of the price of credit in its allocation. Also, because moresavings would become available, borrowers would be less dependent on contactsor inter-company relations with bankers. Moreover, some firms would turnagain to foreign sources of credit, thereby reducing some of the demand forpeso financing. A strategy of generally higher interest rates does not, ofcourse, preclude promotion of specific sectors or types of industry (forexample, capital goods producers, or small-scale enterprises) through speciallow-interest loans. (See paragraph 125.)

124. The combination of less demand from the public sector, recovery ofresource mobilization by the banking system and managing demand for credit byhigher interest rates rather than by lending only to favored clients, wouldbenefit smaller firms even more than larger ones. Availability of credit iseven more important than is the interest rate, and when lenders face excessdemand for credit the smaller firms tend to be the ones that are unable toobtain loans.

125. There is an important role for special purpose trust funds("fideicomisos") in reducing the credit squeeze. Given their small size inthe total credit picture, their primary contribution cannot be the amount ofcredit channeled through them; rather, they could help in allocation and theycan call the banking system's attention to new sectors and new ways of doingbusiness. They can help channel credit to where it is most hard to get (e.g.smaller enterprises), or to sectors that the government wants to promote.They can help soften terms by lengthening maturities. They can allocatecredit to efficient firms, by lending to exporters (as FOMEX and FONEI alreadydo) and by lending on the basis of project appraisal rather than just oncollateral (as FONEI already does). They can, perhaps, demonstrate (in thecase of FOGAIN) that lending to small business can be both useful to theborrowers and profitable to the lenders if higher interest rates yield anattractive spread for taking the higher risks. In sum, the special purposefunds can help to provide funds in areas or in ways where private financialintermediaries' actions are not sufficient to achieve public economicobjectives.

- 45 -

IV. Technological and Sectoral Issues

Employment and Wage Polic;

126. Employment issues, and the more basic issues relating to incomedistribution, can best be analyzed in an economy-wide study. In this reportthe analysis is limited to manufacturing and hence is unavoidably partial.

127. The most important employment-promotion measure that is dealt within this report is maintaining an appropriately high real exchange rate.Increasing the price of foreign exchange, relative to domestic costs andprices, creates incentives in favor of both import substitution and exportsin all sectors of the economy. Thus, if foreign trade policy is changed assuggested earlier, without allowing the effects to be offset by higher costsand prices, employment should increase. As noted earlier, this can probablyonly be achieved with the help of fiscal restraint and monetary and creditpolicies that hold down inflationary pressures.

128. Other important policies dealt with in this report that would affectemployment and income distribution are assistance to small-scale industry.(See paragraphs 141-160 below.) Small-scale firms are more labor intensiveand, moreover, they directly affect a higher percentage of poor people thandoes employment in larger firms becaue not only their workers but often theentrepreneurs have lower incomes than some industrial workers in largerfirms.

129. In addition to these two topics, reducing the large distortion infactor prices in Mexico, which lowers the rate of job creation in manu-facturing, merits consideration. Mexico, as many other developing countries,achieves much of its promotion of industrial expansion by measures that makecapital equipment cheaper, while it uses measures that increase the cost oflabor to achieve part of its income distribution and other social goals.Import duties on capital goods are low, and are often waived completely. Theovervalued exchange rate of the last few years has further lowered the pesoprice of machinery and equipment. Loans for the purchase of fixed plant andequipment are more readily available than for working capital. These measureslower the cost of equipment by 25 to 50 percent, compared to what it wouldhave been in their absence. On the wage side, the "seventh day" payment, the5 percent INFONAVIT contribution, the vacation bonus, the one percent edu-cation tax and the 9 to 12 percent social security tax, the year-end bonus,and the eight percent of profit sharing levy raise the cost of labor by asmuch as 50 percent (see Table 1.11). Moreover, the minimum wage itself raiseslabor costs above a free market level. For workers earning the minimumsalary, these charges are borne completely by the employer, or by his cus-tomers if he can pass on the increased costs in the form of higher prices forhis products. For workers earning above the minimum salary, however, a partof these charges may be reflected in lower nominal wages, and thus be borne by

- 46 -

the workers. The net result of the increased labor charges and the subsidiesto equipment purchasing is that the cost of labor, relative to the cost ofequipment, is perhaps twice what it would be in the absence of these measures.Such a large distortion must affect the relative amounts of the two factorsused, and is especially inappropriate in view of the explosive growth ofMexico's labor force.

130. Since these fringe benefits, and the minimum wage, are not availableto many workers, distortions and inequities are created. Migration from ruralto urban areas, always sensitive to wage differentials, is increased by thehigher wages available in cities. On the other hand, higher labor costs inthe manufacturing enterprises that must pay these fringe benefits may protectsmaller, "informal" enterprises whtch do not pay them, and thus are betterable to compete. This last effect may be important even if the smaller enter-prises do not produce the same products, because higher prices for productsfrom larger enterprises may shift consumption to some extent to other products,or services, that are produced by informal enterprises or by individuals, andtherefore have lower unit wage costs.

131. A shift toward neutral promotional instruments would increase jobcreation to some extent. Income tax rebates or temporary tax holidays couldbe used instead of subsidies that keep equipment prices low. Benefits forworkers could be financed from general public revenues (which could beincreased by the elimination of tariff waivers recommended earlier and generalfiscal reforms), rather than through wage taxes. On the wage tax side, theprime candidates for change are the INFONAVIT contribution, the education tax,and the social security tax. Financing these benefits from general revenueswould reduce wage costs to employers by about 11 percent for workers on theminimum salary; for higher-paid workers the change would be divided betweenlower wage costs for employers and higher nominal wages for employees.

132. Such changes would also require modifications in laws and insti-tutions. In the case of INFONAVIT, only workers who contribute are eligiblefor INFONAVIT housing. The kind of change proposed above could perhaps beapproached through an intermediate step of financing the fringe benefitsthrough a special, "set-aside" portion of a value added tax, if such a tax issubstituted for the present sales tax, with eligibility for INFONAVIT housinglimited to workers in firms that pay the tax. Legal changes would also berequired to change Social Security Financing. Such changes could be made inways that would increase equity, through broader coverage, as well as effi-ciency.

133. Other labor policies such as job security and annual wage negotia-tions should also be studied for possible modification, so as to reduce theburden to employers without unfairly hurting the employees.

134. Trends in wages and productivity are difficult to analyze becauseof problems in data; only approximate estimates are possible. As measuredby all wages in a sample of firms, average real wages grew by about 7.5percent per year from 1960 through 1964, by about 2.7 percent per year from1965 through 1970, and by about 3.6 percent per year from 1971 through 1976.The annual rate for the period as a whole was about 4.2 percent (see Table

- 47 -

1.12). The real minimum salary, which some economists believe to be a moreaccurate measure of trends in average wages, grew slightly faster: 4.9percent per year over the period. Increases in fringe benefits furtherincreased the real income of workers in the organized urban sector. Outputper worker in manufacturing grew somewhat faster than wages, at 5 to 7 percentper year. This productivity growth, which is much faster than trna observedin most countries, may be mostly attributable to the shift to more capital-intensive processes in a given sector. This shift is itself a result of thedistorted faster prices discussed in paragraph 126. A smaller part of theproductivity growth is due to a shift towards more capital-intensive products;however this shift, as shown in Tables 3.1 and 3.2, has been small.

135. Most of the increase in real wages during 1971-76 occurred in 1976.The annual increase had been under 2 percent through 1975 (as measured byeither the average wage in the sample of firms or average minimum wages); in1976 the minimum wage rose 13 percent while average wages rose about 16 per-cent, in real terms. (All these estimates are based on annual data, and thusapproximate mid-year to mid-year changes. The December-to-December increasein 1976 was even greater.).

136. From 1972 on, wages in Mexico rose relative to those in the UnitedStates, along with the increasing overvaluation of the peso (see Table 1.13).Devaluation in 1976 brought the relative wage back to the level of the late1960's.

137. Returning to a pattern of moderate wage increases should contributeto economic stabilization, export promotion, and employment growth. Thiscould be done by a combination of measures, including systematic efforts toreduce the size of any official nationwide wage increases, revision of theFederal Labor Law to allow contracts of two or three years with pre-agreedwage adjustments, rather than re-negotiating contracts each year, and guidanceof informed opinion toward a recognition that a realistically modest wage costof production is essential for rapid economic growth. Employment growth couldbe further promoted by shifting costs of some fringe benefits from payrolltaxes to general tax revenues, as already noted. Further, current rules inregard to temporary layoffs and termination of employment greatly increase thecosts and risks of hiring workers. Their effect is to make labor costs almostfixed rather than variable, and hence they add to other biases favoring usingmore equipment instead of more labor. These rules might be revised, and theapparent reductions in workers' real wages and job security that might resultwould be more than offset by the beneficial effect of increased output andemployment throughout the economy. It is recognized that many of thesechanges would be difficult to make.

138. In considering the equity aspect of industrial wage policy, it iswell to remember that organized industrial workers are at or above the middleof the income scale in Mexico. A worker earning the average minimum salaryin 1975 received a monthly wage (including profit sharing and the year-endbonus) of about Mex$ 2,056 -- about $160 in US dollars. Since a family with

- 48 -

income of Mex$ 2,056 per month was at the 50th percentile of Mexico's incomedistribution in 1975, and since most families have more than one worker,a typical family headed by a worker earning the minimum wage was above themedian income in Mexico.

139. If real wages were to fall without other suitable measures beingtaken at the same time, there would be a redistributive effect in favorof employers which might well lead to increased consumption by the well-to-do.This could be prevented by (a) liberalization of import controls and increasingexport profitability so that inefficient enterprises are squeezed while thosethat are efficient or can become efficient, and whose productivity is liableto grow quickly making future wage increases possible, would increase theirshare of the market; (b) designing real interest rates, tax measures, andcredit policies so as to induce employers to channel their income into savingsand productive investments rather than into consumption, making future employ-ment increases possible.

140. To keep product prices from unwarranted increases, a non-inflationary macroeconomic policy is obviously a sine qua non. Two addi-tional measures might help achieve stable product prices. The more importantand effective measure would be to eliminate import licensing. This wouldlimit price increases to those in world markets. It would create a structureof prices among products that would induce greater growth in products Mexicoproduces efficiently, and would also increase the motivation for efficiencyand quality improvements by providing a reasonable amount of competition fromimports. A second measure that might also be temporarily useful during aperiod of stabilization would be price agreements -- widespread voluntarylimits on allowable price increases -- rather than spotty controls on selectedproducts. Experience in other countries shows that this form of restraint,although virtually useless by itself, can be useful as part of a stabilizationprogram. If monetary policy, fiscal policy, and wage policy are designed toform a coherent package to reduce inflation to a given target level, thenprice restraint set at or near the same target can help to condition expecta-tions and generally help achieve the target. However, experience worldwidealso shows that controls without the rest of the package, or over too long aperiod, are not effective in restraining the overall price level and inducedistortions in relative prices, investment, and eventually in output. It ispossible that the "Alianza para la Produccion" and price-control agreementsfor wage goods may furnish a useful part of the framework for effective pricecontrols in Mexico.

Small and Medium-Scale Industry

141. Overview: Small and medium sized enterprises (SMI), defined asthose with up to 250 employees, play a very important role in manufacturingin Mexico. According to the 1970 Census, they accounted for 45 percent of

- 49 -

production and 60 percent of employment in the sector; moreover, these esti-mates almost certainly underestimate their true importance because the Censusmisses smaller enterprises proportionately more than larger ones. In nearlyall industrial subsectors SMI enterprises predominate by number of firms, andoutside the thr'e largest cities the vast majority of industrial enterprisesare small or i-!ium sized.

142. Small enterprises (those with up to 25 employees) represent over90 percent of the total enterprises comprising the SMI range, and on averagehave only 4 to 5 employees. Medium sized enterprises (those with 25 to 250employees), although they represent only 10 percent of SMI enterprises, con-tribute 80 percent of value added by SMI firms and provide 60 percent ofemployment. They average 75 workers per firm. Small scale firms are gen-erally much less capital intensive than medium and large scale firms butin many branches of industry they operate efficiently and competitively.

143. On average SMI enterprises appear reasonably profitable, reportingearnings of 10 percent on sales and 18 percent on equity capital. Neverthe-less, in common with enterprises of simiiar size in other contries, many SMIin Mexico have deficiencies in accounting, administration, production andmarketing which stem from the small size and lack of specialization of theirmanagement team. They also encounter greater difficulties in securing ade-quate financing from normal commercial sources, and suffer from the tendencyof industrial policies to favor the larger enterprises. All these problemsare particularly serious in the smallest firms.

144. Given their great number, their labor intensiveness, and theirpredominance outside the main cities, SMI can clearly play a major role inachieving national goals for employment generation and regional development.Furthermore, SMI enterprises provide the seed bed for the development ofnew entrepreneurial talent and for upgrading the skills of the labor force,and by their linkages with large industrial enterprises and with other sectorssuch as agriculture they affect the entire economy. They also produce a largepercentage of mass consumption goods, and thus increasing their output andkeeping their costs down could be a useful ingredient in a price stabilizationpackage. Some strengthening of the support provided to SMI is thereforeclearly justified.

145. Industrial policies and SMI: Certain aspects of present policiesof industrial protection, export incentives, employment and wages, anddecentralization are relatively disadvantageous for SMI in general and smallfirms in particular.

146. The existing system of protection in Mexico, which depends moreon quantitative controls than on tariffs, tends to create difficulties forSMI enterprises mainly in the supply of inputs. * In a recent CANACINTRAsurvey of SMI, a high proportion of firms complained of high raw materialprices and excessive price fluctuation, shortages of production inputs, anddelivery delays causing production losses. Production problems were alsocaused by poor and inconsistent quality of available raw materials. Whilethese problems also affect some larger enterprises, they are more acute for

- 50 -

small firms which have weak purchasing power, limited resources to financelarge inventories and more difficult access and lower leverage when applyingfor import licenses. Some smaller firms also have more difficulty than dolarger firms in assuring protection for their output through denial ofimport licenses. A shift in the protection system towards tariffs and awayfrom quantitative restrictions, particularly for industrial raw materialsand intermediate goods, would be welcomed by the majority of SMI firms.

147. While many SMI firms are producing goods that are potentiallycompetitive in international markets, comparatively few are taking advantageof existing export incentives (tax credits, concessionary credit, duty exemp-tions, etc.). The bulk of Mexican exports come from the larger firms, al-though in some subsectors such as food, textiles, apparel and footwear asignificant proportion of exports do come from smaller firms. Despite recentefforts by the Instituto Mexicano de Comercio Exterior (IMCE), many smallenterprises find it difficult to get adequate information regarding demand,prices, qualities and styles in external markets and to make appropriatecontacts with foreign buyers and distribution channels. In addition, smallerenterprises often do not have sufficient volume of production to interestprospective buyers and lack confidence in their own ability to operate suc-cessfully in the more sophisticated and exacting world of export markets.To help overcome these natural disadvantages, further attention might begiven to strengthening the system of intermediation between SMI enterprisesand their potential export markets. This might be done through the establish-ment of trading companies which would develop export contracts and sub-contract production to a number of small firms -- as is already being donein the shoe industry. Alternatively, more active cooperative efforts amongthe SMI enterprises might be encouraged through chambers of commerce andtrade associations, as has been achieved in exports of fruit and vegetables.

148. With regard to employment and wages policies SMI firms also havesome disadvantages. Here the disadvantages are greater for medium-sizedfirms, because many of the smallest firms do not always follow the regula-tions (and in fact thus gain an advantage against their larger competitors).Because SMI firms are generally much more labor intensive than large firms,labor costs and employment regulations have a much more important influenceon their production costs. However, there is a tendency for employment andwage policies to reflect the situation and payment capacity of large firms,because of the latters' greater visibility and the greater strength of theunions which represent their workers.

149. In general minimum wages do not appear to present serious difficul-ties to small enterprises, especially since the legal minima are differentiatedby region. However, a high proportion of SMI enterprises consider that thelevel of social and other non-wage benefits for workers, which add about 50percent to direct labor costs, is becoming a serious burden. In addition,other aspects of labor legislation such as job security, severance pay andminimum hours of work substantially reduce the flexibility of smaller firms.The severity of these regulations tend to make firms cautious about expandingtheir labor force to take advantage of market opportunities, and tend toencourage them to switch to more capital-intensive methods as they expand.

- 51 -

150. Incentives to promote the decentralization of industry, includingfiscal incentives, direction of credit through trust funds and the establish-ment of industrial parks, do not appear to have achieved much success withSMI. Fiscal incentives available are mostly subsidies to capital and thusfavor the larger, more capital intensive firms. About one third of SMI firmslocated outside Mexico City, Monterrey and Guadalajara have been able tobenefit from the fiscal incentives, but it is doubtful whether many smallenterprises based their locational decisions on the availability of theseincentives, or whether the existence of these incentives significantlyinfluenced their creation or viability.

151. Loans discounted with FOGAIN bear slightly lower interest rates tothe borrower outside Zone 1 (the 3 big cities) but the differences are toosmall (1 or 2 percentage points) to provide any significant incentive. Fur-thermore, because banks and financieras receive the same margins, irrespectiveof zone, on loans discounted by FOGAIN, SMI firms located outside the 3 majorcities have had no advantage in access to credit. FOMIN has also tried togive priority to Zone 3 (the least developed part of the country) in its equityinvestments, but overall its impact has been small compared to the needs ofSMI in the Zone (only 24 new enterprises in Zone 3 have been assisted so far).Under FIDEIN's industrial estates program, most lots sold have gone to medium-sized and larger enterprises primarily because the costs of purchasing eventhe smallest available lots and building a simple factory are beyond the scopeof most small enterprises, and adequate financing for such projects has notbeen available to the smaller firms. FIDEIN has developed proposals to con-struct factories for lease to small enterprises and to construct commonservice facilities for groups of small enterprises, but has lacked the fundsto implement these proposals.

152. Finance: The accelerating inflation and tighter monetary controlsince 1973 have reduced credit availability, especially for the smaller firms.By 1974 about 30 percent of SMI firms had to supplement credits obtained fromnormal banking channels by funds borrowed from money lenders and other un-official sources, and less than half of SMI firms were able to meet all oftheir credit requirements. The existence of rediscounting institutions likeFOGAIN has not made a substantial contribution to improving the access tocredit for the smaller firms. In its 22 years of operation to date, FOGAINhas discounted credits to about 10,700 SMI enterprises, which represents only14 percent of eligible enterprises. Even more important, FOGAIN has financed60 percent of eligible medium sized enterprises but only 9 percent of eligiblesmall enterprises. This difference arises because the intermediary banks whonormally carry the credit risk prefer to lend to medium-sized enterprisesunder prevailing conditions of FOGAIN discounts. Transaction costs are higherfor small loans, but FOGAIN lending margins are the same regardless of loansize. It is usually easier to obtain adequate collateral from medium-sizedborrowers and FOGAIN's guarantee facility is not sufficiently attractive toencourage banks to lend to firms with inadequate collateral. Moreover, therudimentary accounting systems of many small enterprises make it difficult forthe firm and costly for the banks to prepare the basic information required toobtain a FOGAIN discount. For FOGAIN to facilitate access to its discounts by

- 52 -

small firms, it may be desirable to review the appropriateness of its lendingconditions and to increase the attractiveness of its guarantee arrangements.In this context it is important to recognize that access to credit is evenmore important to small enterprises than concessionary interest rates.

153. FOMIN, the other trust fund that mainly serves SMI, is not a redis-counting mechanism but assists SMI enterprises directly through minorityinvestments in equity capital. The majority of FOMIN's investments are incompanies whose sizes fall in the middle to upper portion of the SMI range.The scale of FOMIN's operations is relatively small compared with those ofFOGAIN, and the transaction time and costs of its individual financing oper-ations are inevitably very much greater. While FOMIN is providing a usefulservice in facilitating the creation of new enterprises and the expansionof certain existing enterprises, its impact on the problems of small enter-prises is likely to remain limited, unless it can find ways to reduce theassociated transaction costs and develop new forms of financing that are morein keeping with the characteristics of small enterprises. Generally smallenterprises find it advantageous to be structured as family concerns orpartnerships for fiscal reasons, but this makes it difficult for FOMIN toparticipate as an investor in common stock. In addition, small enterpriseswould find it uneconomic to employ external auditors and provide the reportinginformation normally required by FOMIN. Perhaps some form of quasi-equityloans with low interest and principal repayments in the early years, orsubordinated loans with convertibility features, would be more appropriateinstruments in the case of small enterprises.

154. Smaller enterprises have similar problems when dealing with othertrust funds. With FOMEX (concessionary export financing) they must first finda bank prepared to accept them as a credit risk; with FONEP (direct loans forpreinvestmerit studies) they must also satisfy conventional commercial lendingcriteria.

155. Technical assistance: SMI enterprises in Mexico suffer from a widerange of problems apart from limited access to finance. These problems areassociated with enterprise size and the background of the entrepreneur and arenot fundamentally different from those facing small industries in other indus-trialized and semi-industrialized countries. They may include: (a) inadequatefinancial management and accounting; (b) poor production planning and control;(c) poor quality control; (d) difficulty in keeping abreast of technologicaldevelopments; (e) limited knowledge of how to expand into new markets; and(f) management weakness in areas such as purchasing, inventory control, laboradministration, etc.

156. Despite the availability of numerous public and private institutionsoffering specific types of technical assistance, comparatively few SIII enter-prises, particularly small enterprises, are receiving appropriate technicalassistance to help overcome their particular problems. The reasons for thisare several. Many small enterprises are unaware of their managerial and tech-nical deficiencies and therefore do not seek outside help in diagnosing thesedeficiencies. In addition, the entrepreneur is often unaware of what sources

- 53 -

of technical assistance are available, and has not readily available funds orsources of credit to finance such assistance. Existing technical assistanceinstitutions direct their attention mainly to larger companies, and the con-tent and cost of their services is often inappropriate to small enterprises.Furthermore, most of these institutions concentrate their activities in thethree largesL cities and are not known to, or easily accessible by SMI enter-prises located in other regions.

157. To combat this lack of information and lack of access, a strategyof linking the provision of technical assistance more closely to the provisionof financial assistance might help. Banks and financieras would try to helpidentify the non-financial problems of their smaller clients when they areevaluating a loan application. Nacional Financiera, acting as a direct lenderto SMI, and other public sector and mixed institutions, could be encouragedto take the lead in such a program.

158. The system for delivering technical assistance to SMI needs to bestrengthened in terms of geographic coverage and relevance to SMI. Thismight be accomplished by (a) creating a regionally based extension servicefor small industries; (b) establishing a network of small business advisorycenters at provincial locations in association with local chambers and tradeassociations; and (c) coordinating much more closely the scope and contentof the ongoing technical assistance programs, to develop a more comprehensiveand appropriate package of technical assistance support for SMI.

159. Better arrangements are also needed for financing the cost of tech-nical assistance. While part of the cost of technical assistance could perhapsbe capitalized with the loan and recovered from the enterprises assisted, thecost must be spread over a reasonable time to make these services affordable.In practice, a package of financing arrangements involving contributions to thelenders' overhead costs by public and private sector bodies, higher interestrates to the borrowers on loans to SMI discounted with FOGAIN, and fees chargeddirectly to recipients of technical assistance with appropriate credit arrange-ments being made available, will probably be required.

160. Need for coordination and planning: While many institutions areproviding support to SNI, there are still gaps in the availability of someimportant services, and the means by which recipients can pay for servicesoffered are deficient. Insufficient contact between the institutions and SMIenteprises often results in a lack of awareness of what services are availableand in inappropriate design of these services from the point of view of therecipients. To concentrate improvements where they would be most useful, itmay be advisable to establish a high level body responsible for formulatingand monitoring the implementation of national policies and programs in supportof SMI, and for coordinating the activities of the numerous institutions in-volved. A small committee composed of high officials from the most importantinstitutions involved, and from SMIs, might be more effective than a larger orseparate agency. Special emphasis is needed on the closer integration offinancial and non-financial assistance, and on design of programs aimedspecifically at the smaller enterprises in the SMII range.

- 54 -

Capital Goods

161. The situation: The capital goods sector in Mexico is less welldeveloped than the economy's size and level of development is able to support,and the kinds of goods that are produced seem to be poorly related to Mexico'slikely comparative advantage. A wide variety of heavy machinery and equipmentis produced by about 80 large and medium-scale enterprises, but productionis largely limited to import substitution of relatively unsophisticated finalproducts. Production of intermediate inputs is poorly developed.

162. Progress in domestic production of capital goods can help provideMexico with technology appropriate to her needs, and can promote technologicaland scientific advance in general. However, these relations are two-edgedswords: just as efficient development of capital goods production could bringmany advantages to Mexican development, inefficient growth of this sector wouldspread high costs and technological backwardness throughout the economy.

163. A recent study found that Mexico's production of capital goods wasconsiderably retarded (Gomez Palacio, 1976). Unfortunately international com-parisons are difficult because consumer durables are often lumped with capitalgoods in the data. The study notes, for example, that in 1970 Mexican produc-tion was less than that of Brazil or Argentina in each of four major branchesof metal products industries, except for electrical equipment where Mexico'sproduction exceeded Argentina's, partly because of assembly plants. Mexico'slag was most marked in non-electric machinery, where her output was only one-third that of Argentina and one-fourth that of Brazil, while apparent consump-tion of capital goods in Brazil was only about twice that of Mexico. Mexico'slag in non-electric machinery and in transport equipment is also shown inTable 1.14, which shows imports in relation to domestic consumption. Inmachine tools, Mexico produced only 7 percent of her consumption in 1970,while Brazil and Argentina produced 54 and 49 percent, respectively--eventhough Mexico's consumption of machine tools was higher than that of Brazilor Argentina. Trends since 1970 have put Mexico even further behind.

164. The problems of capital goods manufacturing in Mexico can be seenthrough examination of four sub-sectors: the foundry industry, which providesinputs to a wide variety of products; the machine tool industry, which is agood indicator of the level of manufacturing sophistication achieved by acountry; metal fabrication, which includes many labor-intensive special ordergoods; and heavy electrical equipment, which supplies goods mainly for publicenterprises.

165. The amount of foundry capacity in Mexico, above 470,000 tons/year ofcast iron and 100,000 tons/year of cast steel, is reasonable for a country ofMexico's size. However, well over 50 percent of this capacity produces vir-tually exclusively for the automotive sector. The remainder of the foundriesare not only small in their total capacity, in relation to the size of theeconomy, but also have major problems of cost and quality, which can be tracedto:

- 55 -

(i) Raw materials - Efficient foundry operation requires rawmaterial supply of consistent and proper grades. Foundry-grade pig iron, used in most industrialized countries, isnot available in Mexico. (Pig iron from the steel millswould have to be treated further to be suitable for foundryuse.) The foundry industry is therefore heavily ri lant on

scrap for making both iron and steel castings. Domesticscrap is in short supply and substantial quantities must beimported, and thus the price is at least somewhat above that

in the US. More important, deficiencies in ability to adjust

to the varying quality of scrap are a major cause of excessivecasting defects in Mexico, which often cannot be detecteduntil some or all of the subsequent machining has been done,

thereby adding further to the cost.

(ii) Productivity - Except for the more efficient automotive

foundries, Mexican foundries average over 100 man-hours/tonof products, as compared with 40-50 man-hours/ton in compa-rable foundries in the United States. Also, rejection rates

are high, above 10 percent.

166. The few Mexican foundries outside the automotive sector that canproduce high-grade castings enjoy a near monopoly, and give delivery dates onorders as long as 6-8 months. Their prices are pegged to the landed price ofimports; however, this suggests either large profits or very lax managementsince labor accounts for about 30 percent of foundry costs in industrializedcountries and Mexican wages, even at the overvalued exchange rate prevailingin early 1976, were only about one-third of US wages. MIexico should thereforehave a substantial cost advantage in foundry products. The reasonably highquality of that part of the foundry sector that produces automotive castingstestifies further to Mexico's ability to produce efficiently in this sector.

167. The underdevelopment of the machine tool industry illustrates thedifficulties surrounding both high precision and simpler machinery manufac-ture in Mexico. From 1970 to 1975 production stagnated at around $5 million;by comparison, in Brazil production over the same period increased fromaround $30 million to over $100 million. In metal cutting machine toolsthere are 3 or 4 makers of simple lathes and milling machines -- all smalland engaged essentially in the assembly of simple imported models. Theprice of a medium-sized center lathe produced in Mexico was over $12,000 (at12.50 pesos per dollar), which was roughly double the world price for such aproduct. Devaluation would not make this machine much more competitive, sincemost parts are imported. While the simpler products are produced at highcost, higher precision machine tools are almost all imported. Mexico couldproduce cheaper simple machine tools, as well as some higher precision pro-ducts, if more appropriate technology could be imported and selective backwardintegration pursued.

168. The situation in the fabrication subsector is better, becausefabricated products (heat exchangers, pressure vessels, cranes, drill rigs,

- 56 -

etc.) generally do not require complex production processes. Nevertheless,before the recent devaluations, local producers had some difficulty competingagainst imports because of difficulties in getting assured access to certainimported inputs, and inadequate specialization and scale of production causedby excessive vertical integration in the industry -- no one likes to rely onsubcontracting to local suppliers, and hence firms produce many inputs them-selves. Moreover, the international trend towards increasingly larger-capacityequipment that demands more exacting designs and manufacturing methods mayfurther reduce the competitiveness of local manufacturers.

169. The electrical equipment subsector has not developed according toMexico's comparative advantage. Domestic production is concentrated onsmaller "off the shelf" items, while almost all heavy equipment is imported.Many of the smaller items are produced at high costs, mainly because of grosslysub-optimal scales of production, while Mexico probably could be competitive insome of the heavy items which are more labor intensive and more specialized --for example, switchgear and transmission equipment.

170. The main reason for this inappropriate development within the elec-trical equipment sector is the way the import licensing system operates. Themarket for heavy electricals in Mexico is dominated by CFE, which has virtuallyunlimited access to imported equipment, available with generous financing and(until recently) at the overvalued exchange rate. In contrast, the market forsmaller equipment consists mostly of private sector firms which must purchasefrom domestic manufacturers because they cannot obtain licenses to import.The heavy electrical sector presents a classic example of how distortedincentives can distort a country's production structure, leading to domesticproduction of some items at high costs while other items that could be producedmore efficiently are being imported.

171. In summary, the capital goods sector in Mexico is less developedthan it might be, its structure may not be appropriate and in many parts itsproductivity is low. Underlying this situation is a basic problem: Uncertainlyabout future demand, caused by lack of planning by customers and the arbitrarynature of import licensing, leads to sub-optimal scale of production. Thelicensing system also leads in some cases, to inappropriate choice of productsfor import substitution. The sub-optimal scale, combined with inappropriatechoice of products, in turn inevitably mean high costs of production.

172. On a more detailed level, the reasons for the low level of develop-ment are: (a) Fairly low protection for capital goods on the average, andhigh exposure to imports of both new and used equipment from the UnitedStates. For private sector importers tariffs are low and often waived whilegovernment agencies, which form a large part of the Mexican market for capitalgoods, have virtually unlimited access to imported equipment and import it atzero tariff rates. Until September 1976 the overvalued exchange rate contri-buted further to the low protection against imports. (b) Lack of creditfacilities through which Mexican producers could compete with favorablefinancing offered by foreign suppliers. The inappropriate structure and lowproductivity of the sector are due to the following factors: (a) the accessof government agencies to imports, mentioned above, drastically reduces

- 57 -

domestic demand for larger and more special equipment, much of which Mexicocould probably produce fairly efficiently. The private sector, which facesmore difficulty in importing equipment, tends to use smaller and more stan-dardized equipment; in industrialized countries this is produced either inmass or in very large series, and hence at lower costs, than can typically beachieved in M-ico; (b) denial of import licenses (to the private sector) forgoods that are available domestically, with virtually no regard to relativecost or quality, results in import substitution which often bears little or norelation to comparative advantage; and (c) lack of analysis of demand, com-parative costs, and resulting definition of priorities among different typesof capital goods and intermediate products used to make capital goods.

173. The demand for capital goods can be expected to grow in pace withthe anticipated investments in oil, petrochemicals, steel, power generationand other capital-intensive sectors. While the total demand is large, it ishighly diverse as to type and specification of equipment and includes somesophisticated items beyond the capacity of local makers to produce. Localdemand alone for some lines of capital goods may not be large enough to sus-tain economic of efficient production; the market therefore needs carefulidentification.

174. Policy issues: Promotion of efficient capital goods production inMexico could be pursued, in part, by (a) provision of an adequate rediscount-ing facility that would enable Mexican capital goods producers to financesales (both domestic and export) on competitive terms; (b) ending preferentialaccess of public enterprises to imported equipment (this means treatment equalto private sector importers both as to licensing, if it continues to exist,and as to tariff payment); and (c) ending or restricting the import licensingsystem, as already recommended for manufacturing as a whole, so as to increasespecialization, scale of production, and quality and price competitiveness.

175. The fairly low overall protection afforded capital goods, and theaccess to used equipment from the United States, represent important advanta-ges to the Mexican economy. To dispense with them in order to promote produc-tion of capital goods would be very expensive. A reasonable level of protec-tion -- say 15 to 20 percent in a system where the all-manufacturing averageis around 10 or 15 percent and the exchange rate is realistically valued --could be afforded capital goods and imposed on all importers of such goods.Slight additional protection against imports of used equipment might bejustified, especially for sectors with strong export potential, to promotethe use of modern technology.

176. If development of the sector is to be efficient, the strategy foridentification and promotion of capital goods production in Mexico musteventually aim at export markets and not limit itself to import substitution.This approach is important not only to take advantage of scale economies, butalso to assure continuous contact with world standards of quality and price.Reasonable cost, good quality, and appropriate technology are perhaps evenmore important in capital goods production than in other manufacturing,h2cause of the pervasive effects of capital goods on production throughout the

- 58 -

economy. Foreign private investment is often important for access to tech-nology and to export markets. Thus persistent high protection, restrictionsthat unduly impede foreign investment, and weak export incentives would bemost serious impediments to development of the capital goods sector.

177. Other measures to improve efficiency in capital goods might include:(a) comprehensive analysis of the likely growth in demand for various finishedcapital goods and intermediate inputs, taking into account the complex inter-dependence among products and from this estimating possible scales and costsof production, and competitiveness; (b) government promotion of R and D, qual-ity control and testing, and norm setting for the sector; and (c) assistanceto existing firms (especially in intermediate products), to solve problemssuch as obsolete equipment in some lines (e.g., in certain types of casting).Different firms will need different packages of technical assistance andcredit; such help to established firms may be at least as important as crea-tion of major new capacity.

Regional Development and Manufacturing

178. The World Bank has recently issued three studies relating to spatialpolicies in Mexico. Urban Development in Mexico (IBRD 1449-ME, January 31,1977) is about the historical development of Mexican cities and regions;Spatial Development in Mexico (IBRD 1081a-ME, January 31, 1977) analysespolicy options, and The Economic Development of the Isthmic Region of Mexico(IBRD 1080-ME, March 30, 1976) treats in more detail the possibilities fordevelopment in the Isthmus of Tehuantepec. Because of these recent studies,the mission did not study regional questions. However, the conclusions of theearlier Bank reports most relevant to the manufacturing sector, as well asthose of other studies, may be summarized here.

179. Manufacturing is highly concentrated, spatially, in Mexico. TheFederal District and the surrounding State of Mexico accounted for 52.1 per-cent of all manufacturing production in 1975; Nuevo Leon and Jalisco, theStates where Monterrey and Guadalajara are located, had 9.7 and 5.2 percentrespectively, and none of the other 28 states had more than 4.0 percent ofthe national total.

180. Such concentration is not unusual for a semi-industrialized countrysuch as Mexico. Industrialization does not and cannot occur everywhere at thesame pace. The capital city, and occasionally a few others, get a head start,and subsequent development of the transport system, a large local market, alarge and relatively skilled local labor pool, relatively better economic andsocial infrastructure, concentrated sources of information and both publicand private decision makers, and simple "follow-the-leader" risk-minimizinglocation decisions all reinforce each other to strengthen the initial advan-tages.

181. As development proceeds, the largest centers start to experiencegrowing diseconomies such as high land and labor costs, congestion, pollution,

- 59 -

etc., while infrastructure, information, and other positive factors becomemore and more developed in other cities. Thus a counter-trend of decentral-ization starts, usually with'industries that can take advantage of low-wage,low-skilled labor in highly routinized activities. This counter-trend isalready evident in Mexico. For example, Monterrey and Guadalajara, thenation's second and third cities, are growing even faster than M.xico City,and over forty other cities with populations over 100,000 are growing fasterthan the national average. However, Mexico City and its metropolitan areais still not only dominant but continues to attract much additional manufac-turing.

182. Experience throughout the world shows clearly that the forces behindthese trends are very strong, and that even strong policies can have at bestsmall impacts on the trends. Nevertheless, a number of governments, includingthe Mexican government in recent years, have tried to develop backward regionsand/or to slow down growth of major cities, and in general to reduce regionalinequalities. Such attempts have many motives, usually including a concernfor poor people in backward areas and a desire to reduce the negative effectsand management difficulties of fast-growing large cities. In all too manycases, however, the policies adopted are weak, poorly planned, and at oddswith each other.

183. Mexico, like most other nations, has not had a strong explicitspatial policy, and instruments that affected spatial development have notbeen well-coordinated--at least until very recently. Among the most importantmeasures (both those designed with regional objectives in mind and those whereregional effects are unintended by-products) have been the following:

(i) A number of tax exemptions have been available, since 1972,to industries that located outside the three largest metro-politan areas. Unfortunately, these incentives are both toosmall to affect most location decisions, and are availablefor plants that locate in several high-income, highlyurbanized, rapidly growing areas as well as in poorer andmore backward areas. Therefore, the main effect of theincentives has been to increase profits for firms that wouldhave located in these growing areas in any case.

(ii) Industrial parks, complexes, and cities, and commercialcenters, have been set up in many places, especially since1971. A few of these have been quite successful, such asthe Queretaro "industrial city." However, most have metwith but little success because the main benefit provided--physical infrastructure--is not sufficient to attractmost business firms to the unfavorable locations chosenfor many of the sites.

(iii) A number of programs assist small and medium-sized industries(see paragraphs 141-160). Almost all business firms outsidethe three largest cities are small enough to be eligible,and thus the programs may have helped develop some of Mexico's

- 60 -

poorer regions to some extent. About one-third of all eli-gible firms outside the three major cities have been helpedby these programs.

(iv) The maguila program, in which goods are assembled at leastin part from inputs imported in bond and then re-exportedto the United States, has increased growth in several bordercities.

(v) Low prices in Mexico City for water, and nationally forgasoline, diesel fuel, and rail transport of raw materials,have all promoted growth in Mexico City. Many of these priceshave been raised in the last few years, but to help induceeven a little decentralization they would have to be con-siderably higher.

184. Within the last year Mexico has moved towards establishing astronger, coherent and explicit spatial policy. The Law of Human Settlements,adopted in June 1976, provides the legal authority for planning and implement-ing programs to achieve spatial goals. The stated objectives of the law in-clude improved rural-urban integration, more balanced growth as among citiesand regions, promotion of growth in medium-sized cities as alternatives to thelargest cities, greater citizen participation in solving urban problems, landuse control, better provision of urban services, and improvement of the housinglocation-job location-commuting situation within cities. The major powers ofthe law are the Federal government's responsibility to make a national urbandevelopment plan and to coordinate all public sector investment with that plan,local governments' responsibility to plan for and control land use withincities, and the creation of "conurbation commissions" to deal with local gov-ernment problems in urban areas that cross state boundaries. It is still toosoon to tell how these powers will be used, but they do have significantpotential.

185. As explained in the Bank's report on spatial development, citedearlier, it would probably make very good sense for Mexico to adopt spatialpolicies with the two goals of (a) bringing access to markets, jobs, educa-tion, and all the other "urban amenities" closer to people who live far awayfrom the country's three major cities, and (b) slowing down the growth ofMexico City. Affecting the location of manufacturing activity is crucial forthe success of such an attempt. In turn, the key elements of policies toinduce manufacturing to locate away from Mexico City, and also in certainbackward but promising areas, are:

(i) Incentives must be limited to a few areas, and those areasmust have significant potential for development. Experiencein country after country, including recently in Mexico, showsconclusively that incentives that are either not focused orare focused on the most backward regions almost never work.Recent studies by the Bank and others have identified somepromising regions: selected places in the Isthmus ofTehuantepec, the Gulf Coast, and the Lazaro Cardenas areaon the Pacific Coast.

- 61 -

(ii) Incentives must be strong. Tax exemptions such as those nowin force in Mexico are seldom sufficient, although if concen-trated on a few appropriate locations they would be of someuse. An effective package could include (a) tax exemptions;(b) labor taxes on new plants that locate in Mexico CitycomLined with labor subsidies for those that locate in theareas targeted for growth; (c) government investment in bothindustry and infrastructure in the target areas; and (d)increased prices for public utilities in Mexico City,especially in the form of high initial connection charges fornew industrial users.

(iii) Incentives must be enforced for a long time. Regionalpolicies need at least 5 or 10 years to take hold.

(iv) Finally, the explicitly spatial policies must be comple-mented by other policies needed to help the target popula-tions. Promoting growth in selected urban centers willhelp the local and surrounding rural population only ifthese people also have access to credit, prices for theirlabor and their products, education, training or technicalassistance, land, and the other ingredients of economicdevelopment.

II II

- 63 -

ANNEXES Page No.

Table of Contents

ANNEX I: TABLES AND CHARTS

1.1 Imports as Ratios to Domestic Demand, 1967-19744 671.2 Manufactured Exports not including Assembly Plants:

1965-1976 ...... 681.3 Exports as Ratios to Gross Value of Domestic Production,

1967-74 ................................................ 691.4 Mexico's Manufactured Exports (Including Assembly

Plants) by Destination, 1973 .. 701.5 Public Sector Enterprises in Manufacturing - Investment

and Fii%ancial Performance .............................. 711.6 Foreign Investment Enterprises in Manufacturing

- Investment and Financial Performance .721.7 Indicators of Financial Development (1973) .731.8 Nominal and Real Interest Rates. 741.9 Monetary System Balances, 1970-76 .751.10 Private Banking System Income Statements, 1966-75 761.11 Labor Costs, 1976 .771.12 Manufacturing Sector Wages .781.13 Average Wages in Manufacturing compared with the

United States .791.14 Capital Goods Imports in Relation to Domestic

Consumption in Argentina, Brazil, and Mexico: 1973 80

Charts

1.1 Real Effective Exchange Rates for Imports and Exportsof Manufactures .. 81

1.2 Sectoral Distribution of Credits from Banking System... 82

ANNEX II: TECHNICAL NOTE: FREE TRADE EQUILIBRIUM EXCHANGE RATES

2.1 Export Incentives and Disincentives, and EstimatedOvervaluation, 1970 and 1975 .........................,.91

ANNEX III: MEXICO'S INDUSTRIAL STRUCTURE

3.1 Value Added in Manufacturing .953.2 Industrial Structure in Brazil, Turkey and Spain, 1970 963.3 Value Added per Capita in Mexico, Brazil, Turkey and

Spain, 1970 .973.4 Value Added per Worker .983.5 Value Added per Worker in Brazil, Turkey and Spain, 1970 993.6 Actual and Predicted Value Added in Manufacturing

- 1970 and 1975 .100

- 64 -

Page No.

ANNEX IV: SMALL AND MEDIUM-SCALE INDUSTRY

I. PARTICIPATION OF SMALL AND MEDIUM SCALE INDUSTRY IN THEINDUSTRIAL SECTOR ..................................... & ..... 103

II. FINANCING OF SMALL AND MEDIUM SCALE INDUSTRY ................ 111

Fondo de Garantfa y Fomento a la Industria Mediana yPequefia (FOGAIN) .......................................... 112Fondo Nacional de Fomento Industrial (FOMIN) .............. 114Fideicomiso de Conjuntos, Parques y CiudadesIndustriales (FIDEIN) ..................................... 116Fondo Nacional de Estudios de Preinversion (FONEP) ........ 117Fondo Para el Fomento de Exportaciones de ProductosManufacturados (FOMEX) ................................. . 117

III. TECHNICAL ASSISTANCE ........................................ 118

IV. THE OVERALL SYSTEM .......................................... 120

Tables

4.1 Summary of Number of Industrial Enterprises and Enployment(1970) .. 104

4.2 Classification of Manufacturing Enterprises Based on EquityCapital (1970). 104

4.3 Analysis of Industrial Enterprises According to Size (1970) 1074.4 Geographical Distribution of Industrial Enterprises

According to Size (1970) .1084.5 Principal Characteristics of Manufacturing Enterprises in

Mexico According to Size and Type of Activity (1970) 109

This Annex was prepared by Messrs. D.A. Cook, J. Levitsky,T.L. Hutcheson and K. Challa, based on the findings of anIndustrial Sector Mission led by Mr. A. Nowicki (LCl) inOctober/November, 1976.

ANNEX V: CAPITAL GOODS

INTRODUCTION .124

I. GROWTH, STRUCTURE AND RELATIVE POSITION OF THEENGINEERING SECTOR .125

A. Development Trends .125B. Performance of Capital Goods Industries .128C. General Strategic Considerations - Capital Goods Sector 131

- 65 -

Page No.

II. HEAVY INDUSTRIAL MACHINERY AND EQUIPMENT ................ 135

A. Profile of the Industry ............................. 135B. Problems and Constraints ............................ 137C. Fcx-iry Industry .................................... 140D. Machine Tool Industry ............................... 147E. Strategic Considerations for Future Development ..... 154

III. HEAVY ELECTRICAL EQUIPMENT .............................. 157

A. Profile of the Industry ............................. 157B. Problems and Constraints ............................ 162C. Production Costs ................... 1.---...... 1 65D. Development Prospects .168E. Strategic Considerations for Future Development 174

This Annex is based on the findings of Messrs. H. Choi(Consultant), W.H. Oettinger (IBRD-UNIDO CooperativeProgram) and S. Swayambu (Consultant), who visitedMexico in October/November 1976 as members of anIndustrial Sector Mission under the leadership ofMr. A. Nowicki (Sr. Economist, LCI).

Tables

5.1 Recent Performance of the Engineering Sector in Mexico 1255.2 Output Composition of the Engineering Sector .1265.3 Comparative Structure of the Engineering Sector in

Selected Countries .........................-----.... 1265.4 Machine Tool Production ................................. 1275.5 Imports of Engineering Goods ............................ 1275.6 Exports of Engineering Goods ............................ 1285.7 Industrial Machinery .................................... 1285.8 Electrical Machinery .....................-. 1295.9 Capital Goods Imports ................................... 1305.10 Capital Goods Industries ........................ 1325.11 Profile of Representative Plant Equipment Makers in

Mexico .................................................. 1365.12 Status of Foundry Industry .............................. 1405.13 Representative Major Foundries .......................... 1415.14 Machine Tool Production and Trade of Selected Countries 1485.15 U.S. Export of Complete Machine Tools, by Destination ... 1495.16 Profile of Machine Tool Industry - Mexico ............... 1515.17 Selected List of Electrical Equipment Purchased by CFE

During 1973, 1974, 1975 .......................... ........ 1595.18 Demand Trend of Heavy Electrical Equipment in Mexico.... 1605.19 Export Values for Selected Power and Electrical

Equipment 1973-74 ....................................... 1625.20 Profile of Representative Electrical Equipment Makers

in Mexico ............................................... 1675.21 Projected Growth of Power Generating Capacity (MW) 1...... 685.22 CFE's Construction Program of New Power Plants

(1980-90) .............. .... 1705.23 Major Investment Projects in Electrical Manufactures, as

Compiled by CANAME .173

I~~~~~~~~~I

- 67 -

Table 1.1

MEXIC0: Iports as Ratios to Domestic Demand, 1967-1974

S e c t o r 1967 1968 1969 1970 1971 1972 1973 1974

la Petroleum extraction and refiningand coal products .027 .022 .023 .019 .031 .036 .085 .089

lb Basic petrochemicals .069 .055 .063 .067 .085 .101 .085 .079

2 Meat products .014 .009 .009 .015 .014 .010 .020 .0.5

3 Flour milling and baking .002 - - .001 .002 .002 .004 .002

4 Other food products* .021 .018 .018 .025 .024 .031 .040 .054

5 Beverages .007 .006 .005 .005 .011 .014 .014 .013

6 Tobacco .005 .007 .001 .003 - .001 - -

7 Textiles .020 .016 .018 .016 .015 .015 .022 .027

8 Clothing, including footwear .009 .012 .015 .015 .018 .019 .021 .019

9 Wood products .035 .037 .043 .044 .041 .046 .055 .051

10 Paper products .120 .115 .133 .139 .112 .109 .133 .179

11 Printing and Publishing .047 .051 .046 .044 .061 .112 .088 .071

12 Leather and products .011 .011 .013 .013 .012 .019 .017 .014

13 Rubber and products .060 .048 .047 .043 .036 .038 .044 .050

14 Basic chemicals .460 .438 .401 .363 .362 .390 .398 .486

15 Synthetics and plastics .181 .154 .148 .128 .098 .095 .090 .207

16 Fertilizers and insecticides .097 .120 .076 .057 .076 .081 .070 .099

17 Perfumes and soaps .009 .009 .008 .006 .008 .010 .011 .016

18 Pharmaceuticals .126 .170 .136 .122 .141 .129 .119 .110

19 Other chemicals .146 .144 .135 .146 .120 .139 .156 .181

20 Non-metallic mineral products .036 .037 .036 .031 .026 .025 .029 .027

21 Basic metals .078 .065 .063 .072 .056 .050 .077 .120

eMtal products n.a. n.a. n.a. .053 .047 .058 .057 .053

Non-electric machinery n.a. n.a. n.a. .514 .467 .474 .509 .55022-26 Electric machinery n.a. n.a. n.a. .147 .144 .207 .178 .171

Transport equipment n.a. U.a. n.a. .218 .176 .196 .216 .215

27 Miscellaneous .153 .169 .170 .173 .162 .171 .186 .209

Total .105 .105 .100 .100 .099 .102 .114 .131

* Includes sugar

Source: Nacional Financiera, 1977.

lable 1.4

Mexico: Manufactured Exports Not Including Assembly Plants: 1965-1976(Million dollars)

lst Half

1965 1970 1971 1.972 1973 1974 1975 l275 1l96Food products an-, ;w7wagesa/ 42.0 53.6 70.7 77.0 105.2 142.9 116.3 66.2 80.0

Taxtiles, clothing :ad footiear 28.8 38.3 50.8 77.7 167.7 247.8 141.1 74.8 80.0

Chenidcals 43.5 81.4 90.0 102.4 152.3 259.o 204.2 106.3 107.3

1kchinery and trR-c;-n equipmntb/ 5.8 61.0 75.3 106.0 241.4 249.3 269.8 126.6 126.6

Iron and Steel 23.8 33.6 57.9 67.6 37.1 50.0 38.1 19.9 16.8

Printed books 5.7 17.4 11.8 12.8 18.0 23.9 23.0 I1.9 1.5.9

Glass and glass -=a'cts 4.8 8.5 13.3 18.3 21.6 25.9 25.9 6.1 17.2

Other manufacture - 48.6 59.7 84.4 113.1 94.6 243.5 250.9 118,6 146-8

203.0 353.5 454.2 574.9 837.9 1,242.3 1,069.3 I 530.4 590.6

Excludes sugar but includes tabacco,

Includes electronics and parts.

C/ Excludes primary nonferrous metals and petroleum refining.

Source: Banco de Mexico, Indicadores Economicos, varios issues; data from 1974 on are provisional.

_ 69 -

Table 1.3

MEXICO: Exports as Ratios to Gross Value of Domestic Production 1967-1974

S e _ t o r 1967 1968 1969 1970 1971 1972 1973 1974

La Petroleum extraction and refiningand coal products .036 .029 .031 .026 .020 .012 .012 .040

lh Basic petrochemicals - - - - - - - -

2 Meat products .049 .070 .075 .073 .067 .076 .062 .0283 Flotur milling and baking - - - - - - - -

4 Other food products* .119 .122 .115 .109 .106 .116 .126 .1255 Beverages .004 .004 .004 .004 .005 .008 .009 .0116 Tobacco .031 .024 .040 .046 .048 .054 .081 .0807 Textiles .033 .024 .026 .022 .028 .038 .063 .0758 Clothing, including footwear .006 .006 .007 .010 .010 .015 .012 .0189 Wood products .031 .036 .043 .038 .050 .066 .052 .05610 Paper products .043 .041 .042 .041 .034 .036 .031 .03111 Printing and Publishing - - - - - - - -12 Leather and products .014 .013 .017 .014 .009 .010 .004 .00813 Rubber and products .008 .017 .023 .027 .041 .041 .027 .03014 Basic chemicals .100 .088 .096 .093 .092 .096 .118 .17115 Synthetics and plastics - - - - - - - -

16 Fertilizers and insecticides .016 .022 .048 .078 .081 .105 .089 .10717 Perfumes and soaps .027 .024 .020 .017 .018 .017 .018 .02218 Pharmaceuticals .109 .099 .098 .082 .089 .067 .086 .11019 Other chemicals .033 .028 .024 .030 .021 .028 .035 .05720 Non-metallic mineral products .021 .027 .027 .025 .036 .044 .041 .03921 Basic metals .022 .032 .042 .032 .052 .058 .029 .030

[Metal products n.a. n.a. n.a. .009 .010 .014 .015 .019Non-electric machinery n.a. n.a. n.a. .043 .054 .059 .094 .102

22-26 Electric machinery n.a. n.a. n.a. .008 .017 .017 .020 .027Transport equipment n.a. n.a. n.a. .032 .037 .042 .060 .059

27 Miscellaneous .024 .027 .028 .033 .040 .040 .048 .055

Total .036 .037 .040 .039 .043 .045 .045 .050

* Includes sugar

Source: Nacional Financiera, 1977.

Table 1. 4 Mexico's ManuSactured Exoorts (Ic1udinf As5embly Plnts) bY DestinatiOn. 1973

SITC Other Other Other Cootrl"Code Deacrintion Total U.S. EEC JnDn Cada Developed LAFr Latin Arurica Devseloing Pnned

5 Chanicalb 161.5 41.0 32.9 5.7 1.6 3.1 42.3 214.2 9.9 0.8

6, Manufactures Classified Mainly by

micue 68 Material, Les Non-ferrous Metals 292.5 190.5 18.5 21.7 9.3 10.8 12.9 21.7 2.5 4.3

7 Macainery and Traport Equipnnt 682.3 577.8 22.7 6.7 7.8 1.5 45.1 17.6 2.7 0.14

8 Iaellaneons Manufactues 281.9 231.4 6.6 1.2 7.7 2.9 25.1 6.5 0.4 0.1

5-8. ?otal 1418.2 1040.7 80.7 &5L 26.4 18.3 125. 700 15.8 L6less 68 _ __

prcent Ftstrbtion 0 a 5.7 NEi 1.9S 1.1 8.81 4-9 t.11

51 CheAicel Eglents sad Capows 73.9 14.6 At.? 13 1,1 0.7 16.I 3.t 9.4 0.6

54 Nedicinal nd PharvAceutical Products 32.5 9.3 4.4 0.2 0.1 1.2 4.2 12.9 0.2

,5 Soaps, Permes, ste. 7.1 5.0 1.1 0.2 0.2 0.2 0.4

SO Fertiliser 15.5 6.4 5.7 3.4

59 Cheaicals, Not Elsewhere Specified 24.2 4.4 4.4 0.9 12.1 2.2 0.1 0.1

61 ieaeter " Leather Products 10.8 8.3 1.5 0.8 0.1 0.1

63 Wood Products 33.1 31.6 0.6 0.3 0.1 0.2 0.2 0.1 0

64 Paper and sper Products 12.9 11.1 0.1 0.8 0.9

65 Textile3 115.9 58.6 13.2 12.2 8.5 10.4 1.2 5.4 2.1 4.3

66 Nonneta3lic K(ineral Products 51.4 34.7 0.8 8.14 0.5 0.3 1.7 14.9 0.1

67 Iron and Steel 34-0 24.4 1.8 0.1 3.2 14.5

69 Fabricated Xetal Products 33.0 21.7 0.3 0.1 0.1 5.2 5.1 0.5

71 machinery Ezcept Electrical 15B.1 108.3 9.3 1.7 2.9 0.8 28.0 6.1 0.6 0.4

72 Electrical rachinsry and ElectroLies 418.5 395.8 2.7 3.3 2.5 0.7 9.3 2.5 1.7

73 Transport Equipnent 105.7 73.7 10.7 1.7 2.4 0.1 7.8 9.0 0.3

81 Pluambing and Lighting Equipnt 14.2 13.4 0.6 0.1 0.1

82 Fusmitwe 14.9 14.2 0.1 0.1 0.14 0.1

83 Trael Goods and Riuags 13.4 12.3 0.1 0.9 0.1

84 Clothing 106.4 99.6 3.3 0.1 2.2 0.7 0.1 0.14

d5 Footwear 15.4 14.5 0.8 0.1

86 Inatrweants and Film 18.4 8.7 0.2 0.1 8.6 0.8

89 MisceliUnauos Manufactures 99.1 68.9 2.8 0.8 2.9 2.0 16.4 5.0 0.3

Note: Data for developed countries are imports from Mexico, from World Trade Annual, Supplement. volume 2, United Nations. Data for other countries are exports byMexico, from Co_odity Tr*de Statistics. United Nations. Resulting totals are somewhat higher than those In Mexican export statistics adjusted for assemblyindustry exports.

Table 1.5

u Public Sector EaterPrises in Manufacturin_ - IFve t di cial Perfarf.r ce

I N V E S T M E N T P E R F O R M A N C E

Groas Fied Investment Loas (-) or ?rof1t (.) Loss (-) or Profit C)_______________________________Real_Growth_to rot worth to total assets Debt/Squity

_ _ _ _ __ _ 1971 1972 1973 1974 1974 Rel175 1ro thr 19 1974 1975_(illion peso3) (percent) en

1. Potrochemicals o/ 354 436 541 795 1,760 32.6

2. Fertilizers 236 189 200 279 S63 14.9 7.3 4.3 5.9 2.9 1.4 1.6 1.57 2.02 2.66

3. Subtotal-Chemicals (590) (625) (741) (1,074) (2,423) (25.2) 8.6 7.1 11.5 3.6 2.6 3.5 1.41 1.77 2.26

4. steel 636 397 1,794 3,992 7,944 66.9 bi 67 5.3 1.8 2.1 2.1 0.6 1.21 1.55 2.151/ 5.6 8.5 3.7 2.3 2.7 1.0 1.38 2.10 2.81

5. Sugar & other food & beverages 241 590 1,187 1,397 2,349 56.9 -37.5 -21.0 -18.9 -18.5 -11.3 -10.9 1.03 o.86 0.74

6. Pulp, paper, wood prodecte 73 83 208 428 757 59.5 n.a. n.a. n.a.

7. Trraport equipmnt & machinery 240 411 422 676 1,216 33.2 -51.2 -86.5 -h9.1 -4.8 -5.3 -4.4 9.80 15.41 9.93

8. Other 271 461 201 369 427 -0.6

1. TotiLl V 3.~~ ~~~~~ ~~~~~~~~~~~~0 -2.0 -2.8 -1.1 -0.6 -0.8 1.80 2.21 2.6kA. Sotal 1,859 2,567 4,553 7,936 15,116 01.3.3 -2.6 -4.3 -1.1 -0.7 -1.0 1.95 2.72 3.24

B. otal in 1970 prioss 1,793 2,408 3,687 S,249 9,o46 49.9

Year-to-year growth (percent) 3h.3 53.1 42.4 72.3

C. Total inveostent in aufacturing(in 1970 prices) 9,047 8,056 7,729 8,898 n. .

D. Total public in;stint 28,112 38,217 46,848 53,985 56,127 18.9 7

(in 1970 prices)E. Total private invesuent 51,524 50,660 52,829 54,418 5h,796 1.6

(in 1970 prices)F. Total invee 7nt (private 79,636 88,877 99,677 108,403 110,923 8.6

Public) (in 1970 prices)Reltive Shares

(percent)

Public investmnt in uanufacturing/total public invet_nt (B/D) 6.4 6.3 7.9 9.7 16.1

Public inmsUatnt in nfaetwring/total inventmnt in ssnafacturing(B& 19.8 29.9 47.7 59.0 n.a.

total public inveestent/totalin"stmnt (D/F) 35.3 43.o 47.0 49.8 50.6

Public itest ent in manufacturing/total investment(B/F) 2.2 2.7 3.7 4.8 8.2

W Investmnt in expansion of oil excludedb. Including SICARTSAc/ Excluding SICARTSA

Sourc: Mission's calculations on the basis of information received fron the Ministries of Presidencis and Patrimonio Nactonal.

Table 6b

MEXICO, Foreign Invest,ent Enterprises in Manufacturing - Investment and Perfornce

INVESTMENT (in million pesos, current nrices) P E h F 0 R H A N C E1971 1972 1973 1971 1975

Public 1,859 2.567 4,553 7,936 a.a. . Tax Contribution (1S73)

Private 7,523 6,021 b,993 5,518 n.a. Foreign investment taxes paid or withheld (tilliom pesos) 5,271Total manufacturing taxes paid or withheld (million pesos) 20,297

Total 9,382 8,588 9,546 13,454 15,472 Share of foreign enterprise in total taxes by Manufacturing

Foreign private (1,838) (1,779) (2,670) (3,396) (3,734) b. Exoarts (1S74pt) 26.0 Snare of fin egForeign All Etemrisee a/s .erpim*s in the

- as share of the total 03 19.6 20.7 28.0 25.2 21.1 enteprise nt.rpriae tor ialn orici . to______

- a share of the private (S) 24.4 29.5 53.5 61.5 n.a. Gross sales (billion peasoe) 52,219 324,087 2n,868 16.1Exports (billion peosm)

including maquildoras 10 530 b/ 28,440 17,910 37.0exctuding *aquitadoras 3,090 15.53b 12,1.1.6 19.9Sectoral distribution of fied capital (S) - as of 1975

(US6 million)

Foreign Investent All Investmwnt incuding mqouiladoras 842 2,275 1,433excluding i_quiladorna 247 1,245 998

Agriculture 0.2

Share of axports in sales U)Mining 6.3 including _Aquiladorns 20.2 8.8 6.6

Manufacturing 75.1 100.0 100.0

~f obIOhi lc. I1lonmt (1973) o ereimFoareign esotrprise All enterprise anserprise ine U.

Food & beverages 5.4 7.2 19.2 'Resufactir (Amrsfacturin total (%)

Textiles, shoes, clothing 2.8 3.7 9.5 Total eaployint (ta5 ds) 41.19 2,550 15.8of which - msual workers (260.4) n.m. n.a. .Wiood prod. furniture 0.6 o.8 1.7 f\)

Total wage bill (billion pewso) 17.6 75.9 23.2aper, printing 3.3 4.4 7.7

Aver ag income (in WU equivalent) Jteether, rubber 2.1 2.9 3.9

Cluicals 19.2 25.6 i6.6 per capita of msnual worker 3,508 2,769 /

lon-metalic minerals 1.9 1.4. 9.3per capita of white collar 5,294- 6,829 #

d. Productivity (1970) Selatie (I)Eseic metals 2.6 1.9 17.6

Value added (billion pesos) 21.8 94.6 23.0Non-electrical mchinery 5.0 6.7 3.0Val.. added per worMer (pesos) 69,870 4.3,4.00 161.0Electrical machinery 10.3 13.8 2.9

Trensaport equipent 11.3 15.0 7.2

Others 10.1 13.5 1.4

Cerce 11.4

Transport 0.1

Services 6.9

Total 100.0

& Istilates made on the basis of different, often unrelated studies.Figure includes also a*oe minor exports from sectors other than manufacturing.

J Includes services.Mgxico City only.

Sourcs, Estimated by the Mision on the basia of the following sources,tat of _iationAj Caran nd -_ Cae ta, by Victor Menuol Bernal Sahagm and Anglin Outierres Arriola B 1ernardo Gimdo Car_Crr_m

Iatituto de Ineetig&Oiose tconmiesa, Univrid d llciel A nt de Mexico, 1LO, Oenme, i976.act Of rorsla,o Privar Invsstmj.,~,.,~, Maxie by Harry Robinson and Timothy Smith, StAnford Reseroh in titut., Menlo ark, Calif., 1976.

_ _n elca, Mexico, 19 _, by Fernando Fajmylber & Trinidad Martines Tarrego, Fondo de Cuitura

is Innrnion Etn by Bernardo Sapulvda & Antonio Chmcero, Fondo de Cultura Econodca, Mexico, 1973.° Su r1, Ibxico, Supl_nto del Vol. 26, Iso. 7, Julio de 1976.

Infoemtion received frin the Dirsecion Oeneral del Registro gacional de Inversios. Extra3njere in Oct.-Nov. 1976.

- 73 -

Table 1.7

Indicators of Financial Development (1973)

Non-monetary Deposits Non-monetary Depositsas percentage of GDP as percentage of money

Country

Japan 88 244Germany 57 399United States 55 252Singapore 42 163Taiwan 37 175Korea 30 206Mexico 27 208Venezuela 17 109Pakistan 14 46Argentina 13 61Philippines 10 101Ecuador 8 60Colombia (1974) 6 44Bolivia 6 32Haiti 5 46Cameroon (1970) 3 21Dahomey (1970) 2 10

Source: Calculated from Intern.ional ginancil Statis Definition of non-monetary deposits: Country - line no. from IFS Japan - 35, 45, 46a; Germany -35, 36a; United States - 35, 45; Singapore 35, 45; Taiwan - 35, 45; Ecuador -35. 46a; Bolivia - 35, 45; Haiti - 35; Cameroon 35, 45; Dahomey - 35, 45; Philip-pines 35, 46.

- 7- _

Table 1.8

Mexico: Nominal & Reel Interest Rates

Interest Rate Inflation Real InterestYear (highest deposit rate) rate

1969 10.00 3.5 6.2

1970 11.00 5.0 5.7

1971 10.08 5.4 4.4

1972 9.01 5.0 3.8

1973 9.51 12.1 - 2.3

1974 11.53 23.7 - 9.9

1975 12.00 15.0 - 2.6

1976 11.99 16.0 - 3.4

Average1969-72 10.0 4.7 5.0

Average1973-76 11.2 16.7 - 4.6

Table 1.9 Mexico: Monetary System Balances, 1970-76(end-of-year stocks as percentage of GDP)

r otalDomestically Allocation of Total Credit

Money Non-Monetary Financed Foreign Total To Public To PrivateYear Supply Deposits Credit Liabilities Credit Sector Sector

(1) (2) (3) (4) (5) (6) (7)-1970 12 27 38 8 44 22 22

1971 12 29 41 9 47 24 23

1972 13 30 42 8 48 25 23

1973 13 27 40 10 47 25 22

1974 12 24 36 10 43 25 18

1975 12 25 37 11 46 27 19

1976 12 18 31 13 42 27 15

Source: Bank of Mexico through 1975; staff estimates for 1976.

Minor items are omitted and therefore figures do not add across. However, columns (] and (2) arethe main determinants of changes in column (3); likewise columns (3)and (4) are the most ir 7rtantinfluences on column (5).

- 76 _

Table l.lC

Mexico: Private Banking System Income Statements, 1966-75

Financial Gross Labor Other Adminis-Year Income Expenses Spread Costs at trative Expens- Net

es Spread Profits Profits

(percent of average total assets) (av percentageof equity)

1966 10.5 5.7 4.8 2.3 1.7 0.8 0.8 16.8

1967 10.5 5.9 4.6 2.1 1.8 0.7 0.6 13.8

1968 10.7 6.1 4.6 2.0 1.8 0.8 0.8 18.7

1969 11.2 6.6 4.6 2.0 1.8 0.8 0.8 18.4

1970 12.1 7.6 4.5 2.0 1.8 0.7 0.6 14.6

1971 12.3 7.8 4.5 2.0 1.9 0.6 0.6 14.9

1972 11.7 7.2 4.5 2.0 1.7 0.7 0.5 13.9

1973 11.6 7.1 4.5 2.1 1.8 0.6 0.4 10.9

1974 12.5 7.4 5.1 2.4 2.0 b/ 0.7 0.2 7.0

1975 13.3 7.9 5.4 2.5 2.4 b/ 0.5 0.1 3.4

Source: Comisi6n Nacional Bancaria y de Seguros

a/ Does not include workers participation in profits.b/ Aw.'uit itit prohinmR rolat-d to taxes Anti portfolio losses may overstate

this item.

- 77 -

Table 1.11

Mexico: LABOR COSTS, 1976

(Lxample: Baja California)

Weekly Charge

(pesos)

(1) Minimum wage (122.80 per day,times 7 days) 859.60

(2) Housing tax 42.98

(3) Vacation bonus (122.80 x 15 s 52)2J 35.42

(4) Education tax 8.60

(5) Social security tax (category "R") 75.47

(6) Profit sharing (approx. 859.60 . 52) 16.53

(7) Year-end bonus (122.80 x 30 . 52) 70.84

Total 1,109.44;-'

a/ 15 days of vacations; 52 working weeks.

b/ Divided by 6 working days per week = Mex$ 184.91/day

Excess over the 184.91 _ 1.51 (51%)minimum wage - 122.80

Source: Staff estimates.

Table 1.12

Mexico: Manufacturing Sector Wages

Indices of Nominal Wages Indices of Real WagesYear Average Minimum Prices Average Minimum

Wage Wage Wage Wage(in current prices) (in constant prices)

1960 100.0 100.0 100.0 100.0 100.01961 102.6 100.0 100.9 101.6 97.31962 112.8 120.7 102.8 109.7 117.41963 133.3 120.7 103.3 129.1 116.81964 143.6 148.3 107.7 133.3 137.71965 153.8 148.3 109.7 140.2 135.21966 161.5 172.4 111.1 145.4 155.2 11967 171.8 172.4 114.3 150.3 150.8 X1968 179.5 194.8 116.5 154.1 167.2 11969 189.7 194.8 120.6 158.8 161.51970 197.4 220.7 126.6 156.0 174.31971 215.4 220.7 133.5 161.3 165.31972 228.2 259.5 140.1 162.9 185.21973 256.4 273.1 157.0 163.3 173.91974 328.2 368.1 194.3 168.9 189.41975 371.8 425.6 223.4 166.4 190.51976 500.0 a/ 558.0 a/ 258.7 193.3 a/ 215.7 a/

a/ IBRD staff estimates.

Sources: Average wages from Banco de Mexico, unpublished estimates.Minimum wage: 1960-70: Urban wages in Federal District, from Secretariat of Industry and Commerce

Statistical Yearbook.1970-75: Arithmetic average for the nation, from Minimum Salary Commission.

Prices: 1960-68: Wholesale prices in Mexico City, Banco de Mexico.1968-76: National Consumer prices, Banco de Mexico.

- 79 -

Table 1,13

Mexico: Average Wages in Manufacturing compared withthe United States: 1960-1976

Year Mexico USA Mexican wages as percent-aRe of USA wages

(dollars per hour) (percent)

1960-1965 .49 2.43 20

1966-70 .70 3.03 23

1971 .84 3.57 24

1972 .89 3.81 23

1973 1.00 4.07 25

1974 1.28 4.40 29

1975 1.45 4.79 30

Dec. 1976 a/ 1.18 5.40 22

Source: Bank of Mexico and staff estimates.

a/ salaries are preliminary estimates; exchange rate Of 20.21 pesos per dollar.

- 80 -

Table 1.14

Capital Goods Imports in Relation to Domestic

Consumption in Argentina, Brazil and Mexico

1973

Argentina Brazil Mexico

(Imports as percentage of internal demand)

Metal products 2.4% 5.6% 5.7%

Non-electrical machinery 19.4 29.7 45.6

Electrical Machinery 18.0 17.2 17.6

Transport equipment 3.8 5.6 21.6

Total 9.9 15.8 21.8

(billion dollars)

Total Internal demand

for machinery and equipment 2.3 4.4 3.3

Source: Nafinsa (1977), pp. 212,236.

CHART I

MEXICO: REAL EFFECTIVE EXCHANGE RATESFOR IMPORTS AND EXPORTS OF MANUFACTURES

CASE A271

26 -

25 IMPORTS

zIiu ~~~FREE TRADE22 - - EOUILIERIUM

3*--------------- ---- -- ---- ---- '-- - - -'

w 21 -r

20

X197 9 De 9 t0

sI

1970 1975 D.c. 1916 16

8 CASE SIC 7e

, 25 _

~22 ¢ 24 IMPORTS__-

17~~~~~~~~I

22 z Lr EQtJILIRIUM Pe _

I;aS --I- , I- l

1670 ¶976 C. 176 t 96

Wld au-

CHART 1. 2MEXICO: SECTORAL DISTRIBUTION OF CREDITS FROM BANKING SYSTEM

80

70

6c ___ .__ .___ ___

Industry

50 I

200 Xttt>XL 0 *

- - r~~~~~~~~~~~~~~~~~~~.0 ot o A

40

30

1950 1955 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976

Source Bank ol Ur.9O

Aorud Bank- 17155

- 83 -

ANNEX II: TECHNICAL NOTE: FREE TRADEEQUILIBRIUM EXCHANGE RATES

- 84 -

ANNEX IIPage I

Annex II

Free Trade Equilibrium Exchange Rates

1. The object of this annex is to estimate the exchange rate at whichMexico's balance of payments on current account would have been in equilibriumin the absence of any taxes, restrictions, or incentives on imports or exports.

2. The main use of this "FTE" exchange rate is to permit comparisonsof levels of protection and export taxes at different times. As is well under-stood, protection and/or export subsidies can substitute for devaluation (i.e.,compensate for overvalution). Thus, if in a hypothetical case a country'sexchange rate becomes overvalued by 50 percent (due, say, to domestic infla-tion), and the observed rate of protection increases by 80 percent, in onesense protection has increased only about 20 percent (1.8/1.5) because therest of the increase is not really protection but rather a substitute fordevaluation. (In an extreme case, observed protection in Brazil in 1957 was890 percent: the average cost of a dollar's worth of imports was Cr $164.66while the official exchange rate was Cr $18.50/dollar. -Protection relativeto an estimated equilibrium rate, however, was only 89 percent.)

3. In the present case, "equilibrium" will not be defined in terms ofthe current account only: i.e., imports precisely equal to exports. Rather,it will be recognized that Mexico, as a developing country, will normally runa current account deficit in order to receive net foreign savings. In thethree years in question, Mexico's current-account deficits were 11, 14, and43 percent of exports. The first two values do not seem unreasonable, whilethe third does. "Equilibrium" in 1960 and 1970 is therefore defined as in-cluding the actual deficits in terms of percent of exports, while for 1975the deficit is limited to 15 percent of exports. These deficits imply netcapital inflows of $147 million, $403 million, and $945 million in the threerespective years -- equal to 1.2 percent of GDP in each of the three years.

4. The essence of the present method is to use estimates of actualprotection, export incentives, and price elasticities of demand and supplyof imports and exports to calculate the exchange rate that would induce"equilibrium" in the current account if the protection and incentives wereremoved. For present purposes, this method is superior to estimating "over-valuation" by the amount of higher domestic inflation, because the latterignores relevant changes in the structure of Mexico's production and trade.An estimate of overvaluation that is the same whether Mexico is a net importeror a net exporter of petroleum is not relevant to adjusting observed protec-tion for overvaluation -- even though it may be relevant for other purposes,such as estimating changes in living standards or changes in competitivenessof manufactured exports.

5. There is nothing in the estimated FTE exchange rate that makes itthe right or best rate. In particular, its level depends on fiscal policy,growth of output and changes in economic structure. The correct ratedepends on economic objectives and on what other measures are taken thataffect domestic growth, demand for imports, and supply of exports.

- 85 -ANNEX II

PRVP 2

6. To derive the estimatior formula, define:

M, M' = imports before and after the hypothetical move to free trade;

X, X' = exports, similarly;

esm, eDM =price elasticities of supply and demand for imports;

eSX, eDX = price elasticities of supply and demand for exports;

r, r' F exchange rates (peso per dollar), before and 'after thehypothetical move to free trade;

tM, tX = taxes on imports &nd on exports (in o'kr case, tM, will

be measured by comparisons of domesticanid internationalprices .

and for convenience,iefine the ratios of exports to imports:

Nk =-.,x

Assume that the price elasticity of supply of imports isinfinite. For exports, note that:

4-t = e p)=eA

Q A( pr) DX (1

where Q = quantum of exportsp = foreign price of exports

From eq. (1) an expression .br the change in value ofexports in foreign prices can be derived:

AX Osx (eDX + 1) (r' - r)X e -e r (2)

and therefore for convenience define:

ex =eSX (e DX+1)

eDX e

_ 86 -ANNEX IIPage 3

From the definitions of the elasticities:

H M , eDM ] (3)

X -- X* eX[ r(1 - t ] (4)

Dividing (3) by (4) gives:

- . r' r (1 + tM)

H eDM r(+.)(5)M~ --

X -X ex r' - r (I -X)X r1 - tx)

Transforming the LHS of (5):

ml k'X'3 - =1 t

_ 1 - 1XI

k +l r(l X (6)

t 1 + eX [_r 1]I - 1

1 +eX1t rl t -- 1Substituting the transformed LHS (6) into (5), and solving for

r'/r gives:

r_= (1 e-_ X (7)r (

, { DM \ _ / X /k 't1 +t}t (1 y ) kJ

- 87 -

ANNEX IIPage 4

7. Import protection estimates are taken from Balassa (1971) for 1960,from ten Kate (unpublished) for 1970 and from preliminary M xican go-ern-ment estimates for 1975. For the elasticity estimates, use the mean valuesof two sets of estimates made by Gerardo Bueno:

GBI GB2 Mean

M -3 -1 -2

eSX 3 3 3

eDX -10 -4 -7

Source: GBI: Balassa (1971).

GB2: Bueno (1974). In this article Bueno doesnot settle on one set of elasticities; theones used here are those he seems to thinkmost appropriate.

8. Estimates of the "export taxes" (tx in equation 7) have been made ina more complex way than is usual. The calculations for 1970 and 1975 are shownin Table 2.1. In addition to taking CEDIs and export taxes into account (lines2 and 4), adjustments for a number of other incentives and disincentives aremade. The general principle has been to try to include all government measuresthat affect after-tax profits in export sales, relative to what they would bein a free trade situation. 1/ The effects of each measure are converted intoan equivalent percentage change in before-tax, taxable, export revenue; thisenables direct comparison with each other and with the effects of a change inthe exchange rate.

1/ Most of the estimates do not pretend to be more than approximations;these are preferred to the larger error of simply ignoring the effectcompletely. Firmer estimates would require better data.

- 88 -

ANNEX IIPage 5

9. The methodology can best be explained line by line:

Line 1: For most measures, estimates are made separatelyfor exports of primary products, secondary products, andservices. For services incentives are assumed to be zero,so no figures are shown. (Actual incentives for ser-vice exports, other than the exchange rate itself, aresmall and in opposing directions.) For the others, theweights shown are their share in total exports. Assemblyindustries are treated here as services, since most ofthe measures do not apply to them in any significant way,if at all.

Line 2: Typical value of 11 percent is used.

Line 3: Assumes that two-thirds of CEDIs go to firms thatpay income tax (the rate for which is taken as 42 percent).

Line 4: Estimates of actual receipts: SHCP. Allocated100 percent to primary products.

Line 6: For manufactures in 1975, Balassa's 1973 estimateof 1.5 percent was increased to 2 percent to account forthe greater spread between FOMEX rates and market rates.For primary exports and for manufactures in 1970 (beforeFOMEX existed), 0.5 percent is assumed.

Line 7: Measures here include price controls on inputs,QRs on exports of inputs, and the somewhat easier accessto import permits when the imports are to be used to pro-duce exports. It is estimated that these measures reduceinput costs by 2 percent, on average, and that input costsare 62 percent of gross value of output for manufactures(1975 Census) and 35 percent for primary goods (Staffestimates). These input cost ratios are used in lines 9and 11 as well.

Line 8: This is simply the sales tax, taken as 4 percent.

Line 9: Assume the sales tax, on average, is applied 1.5times to inputs. The shares of inputs in output are asexplained above under Line 7.

Line 11: Here the problem is not only to estimate theeffects of protection on input prices, but also to net outthe as-yet-uncalculated effect of overvaluation. (Over-valuation must not be counted here because under free trade,the exchange rate would increase by the amount of over-valuation and this would increase input costs.) Overvalua-tion was estimated by iteration until the assumption was

_ 89 -

ANNEX IIPage 6

consistent with the result; only the final iteration isihowl,. For the level of protection on inputs (relative to

the official exchange rate), economy-wide levels of protec-tion of 13 and 28 percent in the two years were used.

Line 12: This algebraic total shows the estimated neteffects of all incentives and disincentives, except over-valuation. Economy-wide these were -6.6 percent in 1970and -4.0 percent in 1975. These are the figures used fortx in equation 7.

Line 13 is the estimated overvaluation as calculated byequation (7), including the restrictions of the currentaccount deficit to 15 percent of exports in 1975. Thusthe estimated free trade equilibrium exchange rate wouldhave been about 12.85 in 1970 -- only 2.8 percent abovethe actual -- and about 14.80 in 1975; 18.4 percent abovethe actual.

10. These estimates of overvaluation are smaller than most others. Thetwo main reasons are: (a) The effect of protection on raising the cost ofexport production is quite significant as a share in total export "taxes" --about half in 1970 and one-third in 1975. Taking this effect into accountimplies that moving to free trade would increase exports more than wouldotherwise be estimated, and thus a lower devaluation is required to maintain(or restore) balance of payments equilibrium. (b) Any estimate for Mexicobased on import and export elasticities (as these are), will give a lowerestimated of overvaluation (for 1975 at least), than will an estimate basedon purchasing power comparisons using some time earlier as a base. (See,e.g., Villarreal, 1976.) This is because Mexico handled her balance of pay-ments in part by import substitution and export growth (e.g., petroleum andproducts; tourism). Given these events the exchange rate did not have tokeep up completely with relative price changes to maintain equilibrium.Nevertheless, failure to keep the real exchange rate constant in terms ofrelative prices implies decreasing competitiveness for given export products.

11. For 1960 the data needed to follow the same method are not avail-able. Bueno's estimate of overvaluation in 1960 was 9 percent. Comparingthe present estimate of 3 percent for 1970 to an earlier estimate of 6 per-cent for the same year using a method similar to Bueno's suggests that anestimate for 1960 of 6 percent would be not too far off, and consistent withthe present method. (1.03 x 1.09 = 1.06)

(1.06

12. Thus overvaluation in 1960, 1970, and 1975 is estimated at 6, 2.8,and 18.4 percent respectively.

- 9o -

ANNEX IIPage 7

13. This implies that the net effects of protection on manufacturingwere 17.9, 15.6 and 19.0 percent in the three years considered; the apparentrise in protection in the 1970's has compensated for a roughly equal increasein overvaluation. On the export side, there is no estimate for net exporttaxes in 1960. For 1970 and 1975 they are estimated at 14.4 and 9.5 percent,respectively. (Again this is for manufactures.) Thus the introduction ofCEDIs had a significant positive effect, but was insufficient to make up forthe overvaluation and other disincentives.

14. In the estimates for December 1976, reported in Text Tables 3 and4, a different method was used. Instead of using import and export taxes andelasticity estimates to calculate a FTE exchange rate, the FTE rate wasassumed to remain constant in real terms from its 1975 level. In nominalterms it therefore is 44 percent above the 1975 level, reflecting the amountby which wholesale prices in Mexico increased relative to wholesale prices inthe US. Net export incentives to manufacturers were then calculated as inTable 2.1, the numerical differences from 1975 being that in December 1976CEDIs were zero (lines 2 and 3 in Table 2.1), the effect of protection oninput costs, net of overvaluation, was -.048 (line 11), and the resulting netincentives other than overvaluation were -.093 (line 12), also shown in line 3of Text Table 3.

ANNEX IIPage 8

Iabip 2.1

Mexico: Export Incentives and Disincentives, and Estimated Overvaluation, 1970 and 1975

I temn 1970 11975Primary Secondary Average 1 Primary Secondary Average

1. Weights for Sectors .340 .096 1.000 .239 .191 1.000

(ratios o exports)

2. CEDIs .1103. Adjustment for non-taxability .0534. Export taxes -.079 -.151

5. Sub total -.079 .000 -.027 -.151 .163 -.005

Adjustments:

6. Low interest export financing .005 .005 .002 .005 .020 .005.,. Reduction of input costs;

better access to imports .007 .012 .004 .007 .012 .004S. Sales tax on export sales -.040 -.040 -.017 -.040 -.040 -.0179. Effect of sales tax on input

prices -.021 -.037 -.011 -.021 -.037 -.012

10. Sub total, all incentives above -.128 -.060 -.049 -.200 .118 -.

11. Adjustment for effect of protectionon input costs,net of overvaluation.(Assume overvaluation of 3% in 1970and 19% in 1975) -.034 -.060 -.017 -.026 -.047 -.015

12. Net export incentives, excludirgovervalu.ati on, -. 162 -. 120 -. 066 -. 226 .071

13. Estimated overvaluation,r 1.028 1.184r

Incentives are expressed here as ratios to export revenue at actual prices. In the text, however, net incentives have beerconverted to percentages of what export revenues would have been in the free trade eauilibrium situation.

- 92 -

ANNEX III: MEXICO'S INDUSTRIIAL STRUCTURE

- 93 -

ANNEX IIIPage 1

Mexico's Industrial Structure

1. The structure of production (by type of product) of Mexican manu-facturing, and its level relative to the size of the country, are essentiallysimilar to other countries in more or less similar circumstances--at least atthe 2-digit level of aggregation. Mexico's industrial structure and outputper capita is strikingly similar to that of Brazil, while both countries aresomewhat less industrialized than Spain but rather more than Turkey, whichwere chosen as countries roughly similar to Mexico in size and level of devel-opment (see Tables 3.1, 3.2, and 3.3). 1/

2. In labor productivity, however, Mexican manufacturing was behindboth Brazil and Turkey in 1970, and more similar to Spain (see Tables 3.4 and3.5). However, Mexico's labor productivity rose considerably between 1970and 1975, as measured by the industrial census.

3. Comparison to an international pattern based on income level, popu-lation, and economic structure shows that in 1970 the Mexican manufacturingsector was smaller than the predicted level; the only subsectors above theirexpected values were food, beverages, and tobacco; chemicals and petroleumproducts; and metal products: 2/ Similar analysis for 1975, using preliminaryresults of the 1975 census, shows manufacturing again below its expectedvalue; those groups above predicted levels are (again) food, beverages, andtobacco; and chemicals and petroleum products. Metal products, however,dropped to 5 percent below its predicted size (see Table 3.6). Thusdeviations from the international pattern increased from 1970 to 1975; thesector most above its predicted level in 1970 is also the one that grew mostrelative to its predicted growth (food, beverages, and tobacco), and two ofthe other three sectors above or near predicted values in 1970 ranked secondand third in relative growth (chemicals and paper). The exception is metalproducts, which fell from slightly above to slightly below its predictedlevel. All sectors below predicted levels in 1970 were even further below

1/ The 1975 population and income per capita of the four countries are:

Mexico Brazil Spain Turkey

Population (millions) 60 107 35 40GDP per capita (dollars) 1,190 1,010 2,700 860

2/ Comparisons are to values predicted from equations estimated by Cheneryand Taylor (1968). Intepretation of the total figures is in doubtbecause ISIC sector 39, miscellaneous manufacturing, is not included,and also because of questions as to the appropriate exchange rate.Comparisons among 2-digit sub-sectors or over time, however, are lesssubject to these problems.

- 94 -

ANNEX IIIPage 2

predicted levels in 1975. The rapid growth in food products was a response toMexico's natural advantages in these lines, and probable strong growth indomestic final demand. Growth in chemicals and in paper also responded tonatural advantages, but in these sectors import substitution and exportmarkets were the major sources of growth in demand.

4. There seems to be a relationship, albeit a weak one, between laborproductivity and growth, and also between labor productivity and Mexico'sdeviation from the international pattern. Sectors 27 (paper and products)and 31-32 (chemicals, and chemical petroleum and coal products) especially,show high labor productivity, high growth rates, and are large relative toother Mexican sectors when compared to values predicted by the internationalcross-section. At the other extreme, sectors 23 (textiles), 24 (clothing),28 (printing and publishing) and 29 (leather and products) show low laborproductivity, low growth in output, and large negative deviations from inter-national patterns. These differences are also shown, to some extent, in theexport share of each sector (see Table 1.3); chemicals, petroleum refining andwood products export more of their production than mexican manufacturing onthe average, while clothing and leather export about average levels. (Thetextile sector, with an above-average export share, is not consistent withthis pattern.) This tendency, as well as the export figures in general,suggest that Mexican manufacturing performs well in products that are capitalintensive, high-technology, and/or based on mineral resources, while itperforms less well in traditional, low-technology, labor-intensive processes.This is similar to the conclusions of an earlier study, that Mexico's manufac-tured exports are concentrated in mature, high-technology sectors (Boatler,1975). However, this same pattern is also consistent with the reasoning ofthis report that protection inhibits exports (hence the relatively good exportperformance of sectors not dependent on imported inputs) and that more gener-alized export incentives could result in increased exports of more labor-intensive products.

ANNEX IIITable 3.1 Page 3

MEXICO - Value added in Manufacturin8

(million 1975 dollars)

ector (ISIC) 1965 1970 1975ector ~~~~~~ ~~Value Percentage Value Percentage Value Percentage Annual Growth

Added distribution Added distribution Added distribution Rate1965 - 75

0 - 22 Food, beverage, and 1,380Tobacco 22.7% 2,213 ;!2.7% 2,906 22.7% 7.7%

3 Textiles 574 9.6 773 7.9 818 6.4 3.6

.4 Clothing, footwear,and made-up textiles 319 5.2 424 4.3 396 3.1 2..2

!5 - 26 Wood products andfurniture 140 2.3 245 2.5 317 2.5 8.5

!7 Paper and paper products 211 3.4 325 3.3 459 3.6 8.1

!8 Printing and publishing 216 3.5 325 3.3 345 2.7 4.8

!9 Leather and leatherproducts, except wear-ing apparel 31 0.5 54 0.6 60 0.5 6.8

30 Rubber products 120 1.9 221 2.3 261 2.0 8.1

31 - 32 Chemicals and chemicalpetroleum and coalproducts 881 14.4 1.442 14.8 2,057 16.0 8.8

33 Non-metallic mineralproducts 331 5.4 515 5.3 675 5.2 7.3

34 Basic metal 522 8.5 865 8.9 1,259 9.8 9.2

35 - 38 Metal products 1,303 21.3 2,219 22.7 3,065 23.9 8.9

39 Miscellaneous 91 1.5 137 1.4 203 1.6 8.4

'O - 39 Total :- 28 100.0% 9,758 100.0% 12,821 100.0% 7.6%

Source: Industrial Censuses.

ANNEX III

Table 3.2 Pageh

Industrial Structure in Brazil, Turkey and Spain, 1970

(million 1975 dollars)

BRAZIL TURKEY SPAINSector (ISIC) Value Percentage Value Percentage Value Percentage

Added distribution Added distribution Added distribution

20 - 22 Food, beverage, and tobacco 2,920 17.1% 1,274 32.6% 1,275 13.5%

23 Textiles 1,595 9.3 757 19.4 870 9.2

24 Clothing, footwear and made-uptextiles 571 3.3 14 0.3 478 5.0

25 - 26 Wood products and furniture 788 4.6 31 0.8 521 5.5

27 Paper and paper products 437 2.6 58 1.5 301 3.2

28 Printing and publishing 628 3.7 52 1.3 296 3.1 1

%o29 Leather and leather products,

except wearing apparel 110 0.6 8 0.2 139 1.5

30 Rubber products 333 2.0 51 1.3 235 2.5

31 - 32 Chemicals and chemical petroleumand coal products 2,871 16.8 753 19.3 1,576 16.6

33 Non-metallic mineral products 1,004 5.9 156 4.0 795 8.4

34 Basic metal 1,974 11.6 313 8.0 241 2.5

35 - 38 Metal products 3,483 20.4 426 10.9 2,699 28.5

39 Miscellaneous 360 2.1 15 0.4 46 0.5

20 - 39 Total 17,074 100.0% 100.0% 9,472 100.0%

Source: United Nations Yearbook of Industrial Statistics, 1974 Edition; International Financial Statistics.

ANNEX IIIPage 5

Table 3.3

Value Added Per Capita in Mexico, Brazil, Turkey and Spain, 1970

(US dollars per person)

Sector ISIC) MEXICO BRAZIL TURKEY SPAIN

20 - 22 Food, beverage, and tobacco 43.67 31.47 36.16 37.90

23 Textiles 15.26 17.19 21.48 25.85

24 Clothing, footwear and made-uptextiles 8.37 6.15 0.40 14.20

25 - 26 Wood products and furniture 4.84 8.49 0.88 15.49

27 Paper and paver products 6.41 4.71 1.65 8.95

28 Printing and publishing 6.41 6.77 1.48 8.80

29 Leather and leather products, exceptwearing apparel 1.07 1.18 0.23 4.13

30 Rubber products 4.36 3.58 1.45 6.98

31 - 32 Chemicals and chemical petroleumand coal products 28.46 30.95 21.37 46.84

33 (*on-metallic mineral products 10.16 10.82 4.43 23.63

34 Basic metal 17.07 21.28 8.88 7.16

35 - 38 Metal products 43.79 37.55 12.09 80.21

39 Miscellaneous 2.70 3.88 0.43 1.37

20 - 39 Total 192. 184.06 110.93 281.53

Source: Secretaria de Industria y Comercio - Censo Industrial 1971, Mexico.United Nations Yearbook of Industrial Statistics - 1974 Edition.World Bank Atlas, 1972.

ANNEX IllIPage 6

Table 3.4

MEXICO - Value Added per Worker

(thousands 1975 dollars) PercentIncrease

Sector (ISIC) 1965 1970 1975 1965-75

20 - 22 Food, beverage, and tobacco 4.14 5.83 6.94 67.6%

23 Textiles 3.41 5.00 5.82 70.7

24 Clothing, footwear and made-uptextiles 2.94 3.40 3.22 9.5

25 - 26 Wood products and furniture 2.19 3.24 3.89 77.6

27 Paper and paper products 6.84 8.65 10.65 55.7

28 Printing and publishing 4.36 5.71 6.47 48.4 1

29 Leather and leather products, oexcept wearing apparel 2.96 4.51 6.00 102.7

30 Rubber products 6.83 9.95 13.18 93.0

31 - 32 Chemicals and chemical petroleumand coal products 8.06 10.06 12.-6 53.3

33 Non-metallic mineral products 4.30 5.64 6.45 50.0

34 Basic metal 10.37 12.36 15.89 53.2

35 - 38 Metal products 4.37 6.81 7.11 62.7

39 Miscellaneous 3.61 4.86 5.41 49.9

20 - 39 Total 4.56 4.09 7.50 64.57

Source: Industrial Censuses.

AN'NEX IIIPage 7

Table 3.5

Value Added per Worker in Brazil, Turkey and Spain, 1970

(thouisanti 1975 doll rs)

Sector ISIC BRAZIL TURKEY SPAIN

20 - 22 Food, beverage, and tobacco 8.51 10.70 4.65

23 Textiles 5.06 6.30 4.10

24 Clothing, footwear and made-up textiles 4.02 2.80 3.88

25 - 26 Wood products and furniture 4.12 3.10 3.72

27 Paper and paper products 7.66 5.27 6.27

28 Printing and publishing 8.72 5.77 4.70

29 Leather and leather products, except wearing 1.52 2.66 6.61apparel

30 Rubber products 11.89 5.66 6.52

31 - 32 Chemicals and chemical petroleum and coal 18.64 20.91 9.43products

33 Non-metallic mineral products 5.45 4.33 4.94

34 Basic metal 8.69 6.02 2.34

35 - 38 Metal products 9.02 3.00 4.87

39 Miscellaneous 7.05 5.00 3.83

20 - 39 Total 7.86 7.04 4.95

Source: United Nations Yearbook of Industrial Statistics, 1974 edition.International Financial Statistics.

ANNEX III

Table 3.6 Page 8

MEXICO - Actual and Predicted Valued Added in Manufacturing - 1970 and 1975

1970 1975Actual as Actual as

Actual Predicted percentage Actual Predicted percentagesdeviation deviation

Sector (ISIC) above (+) or above (+) orbelow (-) below (-)

predicted predicted

(million pesos) (percent) (million pesos) (percent)

20 - 22 Food, beverages and tobacco 17,948 15,721 14 43,110 36,299 19

23 Textiles 6,266 13,187 -53 12,126 35,141 -65

24 Clothing and footware 3,441 8,237 -58 5,869 22,159 -74

25 - 26 Wood products 1,985 5,511 -64 4,698 15,188 -69 1

27 Paper and paper products 2,633 2,650 - 1 6,803 6,882 0 0

28 Printing and publishing 2,633 6,496 -59 5,109 17,253 -70 1

29 Leather products 434 853 -49 895 2,102 -57

30 Rubber products 1,793 3,703 -52 3,869 9,240 -58

31 - 32 Chemicals and petroleum coalproducts 11,697 10,834 8 30,507 27,872 9

33 Non-metallic mineral products 4,180 6,647 -37 10,011 17,355 -42

34 Basic metals 7,019 11,767 -40 18,677 34,306 -45

35 - 38 Metal products 17,996 16,969 6 45,449 47,720 - 5

20 - 38 Total excluding miscellaneous 78,025 102,575 -24 187,123 271,517 -31

Sources: Actuals: Mexican Industrial Censuses; preliminary results for 1975Predicted: Staff estimates based on Chenery and Taylor (1968)

- 101 -

References

Aspra, L. Antonio, "Import Substitution in Mexico: Past and Present,"World Development, January-February 1977.

Balassa, Be.a, et al, The Structure of Protection in Developing Countries,Johns Hopkins, 1971.

Bergsman, Joel, "Commercial Policy, Allocative Efficiency and 'X-Efficiency,'Quarterly Journal of Economics, August 1974.

Boatler, Robert W., "Trade Theory Predictions and Growth of Mexico'sManufactured Exports," Economic Development and Cultural Change,April 1975.

Bueno, Gerardo, "La Paridad del Poder Adquisitivo y las Elasticidades deImportacion y Exportacion en Mexico," El Trimestre Economico,April-June, 1974.

Chenery, Hollis B. and Lance Taylor, "Development Patterns: Among Countriesand Over Time," Review of Economics and Statistics, November 1968.

Connor, John N. and Willard M. Mueller, "Market Power and Profitability ofMultinational Corporations in Brazil and Mexico," Report to theSubcommittee on Multinational Corporations, United States Senate,June 1976 (revised).

Economic Commission for Latin America, "La Exportacion de Manufacturasen Mexico y la Politica de Promocion," Version provisional,August 1976.

Fajnzylber, Fernando and Trinidad Martines Tarrago, Las EmpresasTransnacionales, Fondo de Cultura Economica, 1976.

Gomez Palacio, Bernardo, "La Industria Metalmechanica y los Bienes deCapital en Mexico," El Mercado de Valores, November 29, 1976.

Nacional Financiera, S.A., La Politica Industrial en el Desarrollo Economicode Mexico, 1971.

Nacional Financiera, S.A., Mexico: Una Estrategia para Desarrollar laIndustria de Bienes de Capital, 1977

Solis, Leopoldo, "Mexico" in Selection of Industrial Priorities, United NationsIndustrial Development Organization, to appear.

Vazquez Tercero, Hector, Una Decada de Politica Sobre Industria Automotriz,Editorial Technos, 1976.

Villarreal, Rene, El Desequilibrio Externo en la Industrializacion deMexico, 1929-1975, Fondo de Cultura Economica, 1976.

- 102 -

ANNEX IV: SMALL AND MEDIUM-SCALE INDUSTRY

Industrial Development & Finance DivisionLatin America and Caribbean Projects

- 103 -

I. PARTICIPATION OF SMALL AND MEDIUM SCALE INDUSTRY IN THE INDUSTRIAL SECTOR

1.01 The most common definition of Small and Medium Scale Iriustry (SMI)in Mexico is that used by Fondo de Garantia y Fomento a la Industria Medianay Pequena (FOGAIN), a specialized trust fund administered by NacionalFinanciera (NAFINSA), which discounts loans to SMI extended through thebanking system. FOGAIN classifies SMI as manufacturing enterprises havingequity capital between Mex$ 25,000 and Mex$ 25 million (US$2,000 and US$2million prior to the recent peso devaluation 1/). Based on this definitionSMI comprised the bulk of Mexican manufacturing industry in 1970, accountingfor 65% of enterprises, 73% of gross production and 83% of employment in thesector. Enterprises with less than Mex$ 25,000 in equity capital areclassified as "artisan" type industries and are supported through separateinstitutional arrangements. In total these very small enterprises accountfor only 1% of manufacturing output and 5% of employment. 2/ (See Tables 1and 2).

1.02 During the decade 1960-1970 SMI (as defined by FOGAIN) increased inimportance within the manufacturing sector through the creation of newenterprises and the expansion of existing enterprises. Its share of manufac-turing output increased from 68.2% to 73.4% and of employment in manufacturingfrom 77% to 83.2%. This dynamic growth seems to have occurred in two phases.Between 1960 and 1965 growth came primarily from the establishment of new,relatively small enterprises. The total number of SMI enterprises increasedfrom 56,652 to 76,680 but the average number of employees per firm droped from12.2 to 9.5. Total employment in SMI firms increased by only 5% in thisperiod. From 1965 to 1970 the number of firms remained almost constant with

1/ FOGAIN changed the upper limit to Mex$ 30 million in 1975 and is atpresent examining the desirability of further modifying these limits totake account the effects of the recent peso devaluation.

2/ Note that FOGAIN's analysis of SMI is based only on enterprises engagedin manufacturing rather than all industrial enterprises. However, sincemanufacturing enterprises make up the overwhelming majority of allindustry (see Table 1), the percentage figures quoted in this paragraphwould hold even if all industrial enterprises were included. Note alsothat all figures in this section are based on analysis of the 1970Industrial Census. There are significant differences between this Censusand the overall Population Census, with the latter showing considerablyhigher employment in manufacturing. The differences are partly theresult of poor coverage of the small enterprises in the industrialcensus, many of which are not registered with the appropriate authori-ties. In addition, there are differences in the definition ofmanufacturing, with the population census probably including a varietyof commercial activities such as tailoring, banking, etc., in manu-facturing.

- 10i4 -

ANALYSIS OF THE 1970 INDUSTRIAL CENSUS DATA

Table 1: Summary of Number of Industrial Enterprises and Employment (1970)

Average No.Number of Total of Employees

Establishments 1/ Employment per Establishment

Manufacturing Industry 2/ 118,983 1,521,661 13

Petroleum & Basic Chemicals 3/ 28 56,987 2,035

Other Extractive Industries 980 60,586 62

1/ For the purposes of the Census subsidiaries of an industrial group operating atdifferent locations are classed as different establishments.

2/ Including repair and service of machines and metal working industries.

3/ Excluding enterprises engaged. primarily in the distribution of these products.

1/Table 2: Classification of Manufacturing Enterprises Based on Equity Capital (1970)

(Amounts in millions of pesos)

Large Industry SMI Artisan IndustQuantity x Quantity % Quantity

No. of Enterprises 523 0.44 76,753 64.64 41,464 34.92

Invested Capital 43,430 29.64 102,312 69.83 766 0.52

Gross Production 52,088 25.60 149,260 73.36 2,105 1.03

Value Added 18,772 23.68 59,810 75.45 685 0.86

Fixed Assets 37,846 37.32 62,933 62.06 629 0.62

Total Employment 170,770 11.23 1,298,256 83.21 84,549 5.56

1/ Including enterprises engaged in repair and service of machines and metal workingindustries.

- 105 -

growth coming mainly from the expansion of existing enterprises in responseto increased capital investment. The number of employees per firm increasedfrom 9.5 to 17.8 and average capital invested per firm grew from US$50,000equivalent ta. US$107,000 equivalent. During the 1965-1970 period totalemployment in SMI enterprises increased by almost 90%, but the capitalintensity of Srit firms did not increase significantly, capital invested peremployee growing from US$5,200 to US$6,000 equivalent. 1/ Unfortunately,statistics are not yet available from the 1975 census to perform a similaranalysis for 1970-1975, but preliminary results suggest that SMI grew lessrapidly during this period.

1.03 While FOGAIN's definition of SMI is not significantly out of linewith the definitions used in several other countries, it covers too large aproportion of Mexican industry and too broad a range of enterprise sizes andtypes to allow a detailed analysis of the characteristics and needs ofenterprises of different sizes.

1.04 NAFINSA has recently performed some interesting analyses of the1970 industrial census data using the different SMI definition. Enterpriseswith up to 25 employees but excluding "artisan" type enterprises (as definedabove) were classified as small, and those with 26 to 250 employees as mediumsized enterprises. Combined they would account for about 45% of gross outputand 55% of employment in manufacturing. The Bank mission replicated andextended NAFINSA's analysis with the help of the Department of Statisticsof the Secretaria de Programacion y Presupuesto (Ministry of Programming andBudgeting). Tables 3 through 5 summarize the results of these analyses. Theyreveal several interesting differences among enterprises depending on theirsize, type of activity and goegraphic location. These are briefly noted below,with emphasis on the differences between small and medium sized enterprises:

- Over 90% of the enterprises comprising the SMI range have25 or less employees. On average the small enterpriseshave only 4 or 5 employees. Medium sized enterprises aregenerally very much bigger, having 75 workers per firm onaverage.

- Medium sized enterprises, although they represent less than10% of SMI firms, contribute nearly 80% of value added andoutput by SMI firms and provide about 60% of employment.

- Fixed Assets per employee are much higher in medium sizedfirms (US$5,406) than in small firms (US$1,782).

1/ Some of the above differences between the period 1960 to 1965 and 1965 to1970 may be more apparent than real since there were differences in thesampling.

- 106 -

Whereas value added per worker is generally higher inmedium sized firms, value added per unit of capitalinvested is higher in small firms. If a 10% cost ofcapital is assumed, then value added per unit of capitalcosts plus labor costs is slightly higher (by about 10%on average) for medium sized firms than for small firms.

Value added as a percentage of gross output is somewhathigher for small enterprises (40.6%) than for mediumsized firms (37.6%).

While the majority of industrial enterprises belonging toall three size categories are located in the provincialarea identified as Zone 3 1/, the relative concentrationof large enterprises is much higher in the area coveredby and surrounding the three largest cities (Zone 1) thanin the smaller cities and the provincial area. Almostthree-quarters of the manufacturers in the provincial areaare small.

Small enterprises are to be found operating in almost allindustrial subsectors, and in some subsectors such asfood products, garment making, wood products and leathergoods, much of the output comes from relatively small firms.

An overwhelming majority (93%) of the small enterprises areorganized as sole proprietorships with unlimited liabilityfor the owner. In contrast, 83% of the medium sized and 94%of the large enterprises are publicly incorporated companies;the majority of the remaining medium and large size enter-prises are organized as partnerships with limited liabilityto the owners.

To guide the Mexican regional development program, the Government cate-gorized all parts of Mexico into one of three "zones" depending on thedegree of urbanization: Zone 1 includes the Federal District (includingMexico City), the metropolitan areas of Guadalajara and Monterrey andsome municipalities immediately surrounding them. Zone 2 includes10 smaller urban centers, namely the municipalities of Tlaquepaque,Zapopan, Lerma, Toluca, Cuernavaca, Jiutepec, Cuautilancingo, Puebla,San Pedro Cholula and Quaretaro. Zone 3 includes all other parts ofMexico.

- 3107 -

ANALYSIS OF THE 1970 INDUSTRIAL CENSUS DATA

1/ 1/Table 3: Analysis of Industrial Enterprises According to Size (1970)

Large Medium Small Artisan(250 employees) (26-250 employees) (up to 25 (Equity less

employees) than Mex$25,000)

Number of Establishments 1,065 7,820 69,614 41,464

Equity Capital Invested 87,263 48,620 11,122 766(million pesos)

Gross Fixed Assets 62,329 31,713 6,226 628(million pesos)

Gross Production 113,435 78,320 18,531 2,105(million pesos)

Value Added 44,700 29,463 7,533 685(million pesos)

Total Employment 630,444 586,635 279,619 84,549

Gross Fixed Assets/Employee 7,914 5,406 1,782 595(US$ equivalent)

Equity Capital Invested/ 11,072 6,624 3,200 725Employee (US$ equivalent)

Value Added as Percentage 39,4% 37.6% 40.6% 32.5%of Gross Production

Value Added per unit of 51.2% 60.6% 67.7% 89.4%capital invested

Value Added per year per 5,680 4,000 2,160 640employee (US$ equivalent)

Number of employees per 592 75 4 2Establishment

Total Annual Remuneration 31,000 24,000 15,000 3,000per Employee (pesos)

1/ Excluding Petroleum and Basic Chemicals Industries.

- 108 -

ANALYSIS OF THE 1970 INDUSTRIAL CENSUS DATA

Table 4: Geographical Distribution of Industrial EnterprisesAccording to Size (1970) 1/ & 2/

Large Medium Small TotalNumber of Number of Number of Number ofEnterprises % Enterprises X Enterprises % Enterprises X

Zone 1 366 34.3 3182 40.1 27,168 24.5 30,716 25.6

Zone 2 69 6.5 352 4.5 2,258 2.0 2,679 2.2

Zone 3 630 59.1 4286 54.9 81,652 73.5 86,568 72.1

Total 1,065 100.0 7,820 100.0 111,078 100.0 119,963 100.0

1/ Excluding enterprises engaged in petroleum and basic chemicals industries.

2/ Enterprises with 25 employees or less are classified as "small", those with 26 to 250as "medium", and those with more than 250 employees as "large".

- 109 -

�04C0N�O(. C4000000

0

0NN0SNd100�240400.404 0.�04

-' � -V2t2 0 7 -'A4.Of� 40.4.4.400000.40000

0 4. 4 0 *000N000 SC

.5 .� 't s�2 4 � -�-'00000:0

* NN4000444*.4 00.4N4000�O0N000004.4004040.4 0*0400.

- 4 44 0044 40400.400.0* � 4 72&. 4

.oocoo' o-,-c- o.oo0 - 00' oooO.4000N00000

�O0�ON600-00000O 0004

- .4o.oOa.00.4 03340034� 01

000.40404 -c 004 N4000CO.4.4004'OO

000040000000 0040N04NO 3 0Vf0(4O0(�� 44C00040cC00N'�

- V4.-�00 00.40C'-0 22320.,0O.4c.444.0 404�0400N 44 4-. Oor-4001--40 0..N-40OOO.-.0.4O4C404NN0�. 440�.45 404 .4oNNNO.40 0 4-00 N044 8 �C0 CN..0004N.4N0

.4 4.

04�000.400 0 0 -, CO

OONCO 00000N00N04 1 . r�oCoo.4eNOOO0004.4fl0N"o 00.4400040… 4400N C .4 - Ooo...ONOO.-.

00

0.4400C000

0. .j NAO.ONCO.4OC oo.4coooeo"* 04.400040� ONOOCON Q40.4 -

4 .-. 04040404 000c00440 OWe .�u C...

- . *4*0

A' -* *� 04000 *C40400 fo�

- 44ONOO.4OC 000 00(.''�-0 r0 0000-ON S NO.4C e40COON 00 3404.43 Cc 0 C 300 .'NN CCC ON.0.40 0C� 3o

- C0...4400000N000

0.40�00N *� 5 * 0 0-ONONOcO e.�0Ct

4. 4 O04

4.44ONONCNOOOO4NO 0 0. C N NO N - -.5 '�

0tt"k�

044 Nc NO.4400.4 4 0

0 . 44

o 0 COOOONO 00cC NOtION

33 Loco

.44 00.�00O C CNO400

40C04000004C40000000 �3 0 300.0.4 00.00�00N0000.4 3 4C000�00C0 C N� 0.4N.c4N4.4. - 0

5 I 0 ON4ON0000C 000000040.4 �0N000CCC0..N0CC000 4- ; .4 - ON.40 00 C-.4cOO C0000.OOC.4004 NOON 4 4000 NN040N0*0�ot .324 4 -

4 OoO0'4.4OOONONO.4 OCCO.NN 4.-0 4 C..NN0NO400NOON 000C0

3cc e -....- �

0 4 O.4O.04cN0'444N 3400080 .44 0 0 0 0

.40'0034040N0000

(.4U 0

0 4.. NNOON 40440 ONO 4 C 0 3 r-.-.oCO 0-.OOoO c

30Nr-0

3 �0 4.400404fl0 440' 000'000.4N 44 4 ooON..NON4.-.COc o� 0-r N 40NN0000000

0.

40 4.4NON

00

o-.So0000000000NCOO0* 404000040400 0'..'NN0N 0 0.4 -

00 � 40' .4N oN co Nc 04

�'04 .- 'C0'NC 00.4000 0440000000.4Cc 4.�4 CO .40-44 0N400000004004 N N 000000.4

0 00040.0Cc 0000CC 0 C04048 3 3

0.00.4040.40004004000400.4000'

.3 40..0'Nc..4000...N.0..00

0..

no 0 0-00 0.440 0'0'N0'0'0'NNON4 0.4000000.4Cc 0' o.O

,O....0N40N40004O0'.4O 000 .4 -. 040.4000 35

O0'N0 4 40CN0'0N.�0'0C 4-000I S ... NOO 0044 ONNOc 404 NO4C

I 4 .40'04040'4000 4000--N 3 0 004 000040N 0000404400 30 004400440.000 0'0 C..OOOCO 0 NNOOOCOO40'CN

- - - - -- 0.�4 �N.-.004 0400.400004004 COCONCO 50 4000C00 aNON

o C No.4.404 04 44.400.400400.4..

00004.44000' 40400.40000.4 4000.40 0440N0N 4 OC 040004000.4O.4N0' 400 NON .40C000 04 4NNO.40C4 0000

2 2Oc...4 N�NO0400000.4.40400400

0 4 NOON 0N440400040C00.40 3 00.4040.4000 4CC004 0440* 00000.4--N 4 NO.400.40 NO O0NNNNNO0 004 4400

I

- 0 00400000004.440.4400.40 .0.4 4 0-440000040000000000.4 .0 00040400000000000000 .4.400400400400440400.40 4 04...4 44000040040004.4040404 .4 2

10 .4 .44 000000400 0.4004 40 4 4.400400040 400400(4N000.40 .4 N 04.40000 .4

0 .o 0 0 4004.400000000000000

0 00400 0.4.N.44N 0400400 0.4 00000004 4040 cOON 000 0 -.0.j 3 3400.400040000000.4.44.4O 0 40 NOON 0-ON 0 00.4 0 00000000 000 . - � :10o 0 0 0 0 000O0040N4C0C00.0�04

44 00004000004000c0.44444.4 40000' 4000.40.44.400.400 4.

J 440.4404.400 .40 0404000 4440.40 .4.40040.404 00

1. Z 233:±33200040'.400 C

* 4- .4 04404400004000000404 0 .4 .000040000.400400000 COONON.40004 0400004440000 C 0 0 00440000000400400040

4 0 00 0' 00N.4N.4.40N.0400.c 5 C 040 4 C000.�044N0C.� 0404

4. 0 0

o o 00000004004000040000 4.44040.444000000.4040.4040044 040000004004004 000000044.400004000044

4 NO 400000000 00.40000 00000.40000.400.4.4000.440

4 oN-NOON 4.40000.40 0 .40004 4004 00.4000.404O 0 .4 - 0.4 00000000004000

ON e .10

0 0 0 00 0 0 0 .� �0.0

0 4 0

- 2 �0 4

t0

e�ss�. � II

4.0 04.44.00 0044054404.0 004." 00.04. 00000.4.400 0 40 00000o004.4o 4o 40.4040. .4C.44.0.0000.4 0 40.4040. 04.0.0

I I � a

.4 000040044.004404400.44.4 .4000440044.00400.444.44.44 o44-04300.0(400cO 0044-.> 4 0.044100300.0. .404.40.00000110>

- 110 -

- Average remuneration 1/ per employee varies widely (by afactor of 3) among subsectors ranging from about Mex$ 12,000per year in enterprises producing wood and food productsto 11ex$ 35,000 per year for those engaged in basic metalindustries. In comparison, variations in annual remune-ration depending on size are smaller: average remunerationis about Mex$ 15,000 per year in small industry compared toMex$ 24,000 in medium sized enterprises and Mex$ 31,000 inlarge enterprises. Remunerations in the artisan enter-prises, however, are very low, averaging only aboutMex$ 3,000 per year.

1.05 Based on FOGAIN's 1974 study of the enterprises they have financed,SMI firms appear reasonably profitable, earning about 10% on sales and 18%on equity capital. Nevertheless, in common with similar sized enterprisesin other countries, SMI in Mexico and particularly the small enterprisestend to have deficiencies in areas such as accounting, production, financialmanagement and marketing which stem from the small size and lack of special-ization of their management team (typically the owner and his family for smallfirms). The growth prospects of the small firms have been limited not only bythese deficiencies but also by the greater difficulties they have in securingadequate financing from normal commercial sources, relative to medium sizedand larger firms.

1.06 In view of the predominance of SMI enterprises within Mexicanmanufacturing, and their labor intensity and regional dispersion relativeto larger firms, industrial growth will not only be more rapid but also willprovide more jobs and can be more decentralized if SMI are strengthened.Furthermore, SMI enterprise provide the seed bed for the development ofentrepreneurial talent and for upgrading the skills of the labor force, and bytheir linkages with large industry and agriculture and their heavy involvementin the production of mass consumption goods they contributed to other importanteconomic and social development goals. However, if SMI is to make its fullpotential contribution, some strengthening of financial and non-financialsupport to SMI will be required.

1/ Wages or salaries plus other monetary benefits.

- ill -

II. FINANCING OF SMALL AND MEDIUMI SCALE INDUSTRY

2.01 Mexico's well developing banking system, comprising public,private and mixed ownership institutions has been the primary source ofoutside financing for industry as a whole including SMI Commercial banksand investment banks (financieras) make industrial loans and investmentsprimarily from their own resources, but they also have access to discountingfacilities with public sector trust funds, of which FOGAIN is the mostimportant in the case of SMI. During the late 1960s and early 1970s thebanking system developed rapidly with the real volume of outstanding creditincreasing and lengthening in its term. Mexico's open financial systemallowed a free flow of capital into and out of the country, and the longperiod of stabil'ty of the peso exchange rate encouraged US deposits inMexican banks and foreign borrowings by Mexican firms. Foreign exchangeliabilities of Mexican firms grew to roughly one half of their pesoliabilities. Generally, credit was readily obtainable by firms that werejudged to be reasonable credit risks by virtue of their size and reputationor the collateral they could offer. It was mainly the smaller firms thathad difficulties in securing credit. Financial intermediaries madecomparatively little use of the trust funds since they could earn highermargins on resources raised through bonds and deposits.

2.02 Since 1973, accelerating inflation and tighter monetary controlhave slowed down the growth of the financial system and reduced creditavailability. By 1974 access to credit had become a serious problem for SMIwith about 30% of firms having to supplement credits obtained from normalbanking channels by borrowings from money lenders and other unofficial sources,and less than half of SMI firms able to secure most of all of their creditrequirements. The recent major peso devaluation have accentuated this trend.Not only are companies' needs for working capital financing much greater, butthere has been a substantial decline in the volume of resources mobilized bythe banking system. In addition, large companies with heavy foreign exchangeliabilities have switched to domestic borrowing. In these circumstancesdemands for peso financing are substantially in excess of the amounts thebanking system can presently supply. Initial indications suggest that indus-trial credit is likely to remain in very short supply for at least the next2-3 years.

2.03 Financing of SMI by the banking system is supplemented by threepublic sector trust funds all of which are administered by Nacional Financiera(NAFINSA). These are FOGAIN (Fondo de Garantia y Fomento a la IndustriaMediana y Pequena), FOMIN (Fondo Nacional de Fomento Industrial), and FIDEIN(Fideicomiso de Conjuntos, Parques y Ciudades Industriales). Other trustfunds, which are designed to serve industry as a whole provide some supportto SMI for specific purposes. These are Fondo Nacional de Estudios dePreinversion (FONEP) administered by Nacional Financiera to finance preinvest-ment studies and technical assistance activities, and Fondo para el Fomento delas Exportaciones de los Productos Manufacturados (FOMEX) administered byBanco de Mexico to support exporting industries. The activities of thesetrust funds are briefly described below.

- 112 -

Fondo de Garantia y Fomento a la Industria Mediana y Pequena (FOGAIN)

2.04 FOGAIN is a government trust fund administered by Nacional Financierafor developing and financing small and medium scale industry (SMI) in Mexico.It is the oldest and best known of Mexico's SMI institutions, and has beenoperating since 1954. It can rediscount up to 100% of credits granted toSMI enterprises by financial intermediaries--mainly commercial banks andfinancieras but including also credit unions established by groups of smallerenterprises. Traditionally, enterprises with equity capital betweenMex$ 25,000 and Mex$ 25 million have been eligible for FOGAIN discounts, butrecently the upper limit has been raised to Mex$ 30 million and the lowerlimit has been increased to Mex$ 300,000 for enterprises located in Zone 1,i.e. Mexico City, Monterrey and Guadalajara.

2.05 FOGAIN di counts loans for working capital (up to Mex$ 3.5 million),fixed assets (up to Mex$ 4.5 million) or for debt restructuring (Up to Mex$ 7million). Normally, the financial intermediary bears the full credit risk.FOGAIN can guarantee a proportion of the credit, but it has seldom used thisfacility in practice. Interest rates on loans discountd by FOGAIN arerelatively low, ranging from 10% in Zone 3 to 12% in Zone 1, including a marginof 3 percentage points for the intermediary. When lending from their internalresources banks charge effective interest rates (including commissions) in therange 15-25%.

2.06 During 1975 FOGAIN authorized discounting of 2,274 credits amountingto about Mex$ 1.18 billion, of which 56% was for working capital and a further40% for fixed assets. These credits were granted to 2007 SMI enterprises, ofwhich enterprises with equity capital of less than Mex$ 1 million received43% of total credit, and those with equity capital of Mex$ 1 to 3.5 million afurther 36%. More than half of the assisted enterprises had 20 or lessemployees; 60% were located in Zone 3.

2.07 During the period 1961-1971 FOGAIN's operations remained static atthe level of about 750 loans per year. From 1972 on, operations began to in-crease fairly rapidly as FOGAIN became more promotional and coinciding with theperiod of tight liquidity in 1974, FOGAIN made 2,900 loans. Lending remainedat this high level in 1975 and the first half of 1976, but following theSeptember 1976 devaluation FOGAIN has been experiencing a further upsurge indemand.

2.08 FOGAIN's portfolio of outstanding loans is financed mainly out ofequity subscriptions by the Government, loans from Banco de Mexico (resourceFprovided from legal reserves of banking system) and a series of loans fromthe Inter-American Development Bank (IDB). The table below shows the develop-ment of these resources since 1971.

- 113 -

Accumulated Resources Utilized by FOGAINas at End of Period(millions of pesos)

June1971 1972 1973 1974 1975 1976

Equity subscriptions 189.7 289.7 339.7 359.7 409.7 409.7Reinvested Profits 69.9 82.3 88.9 85.0 80.7 81.7IDB Loans 189.3 188.6 283.1 308.4 314.7 327.1Banco de Mexico Loans - - 200.0 500.0 700.0 800.0

Other Loans 4.5 3.8 12.8 38.5 18.7 19.6Total Resources 453.4 564.3 924.5 1,291.7 1,523.9 1,638.1

2.09 From the above table it can be seen that equity has declined as aproportion of total resources from 57% in 1971 to 29% in 1976, whereas Bancode Mexico loans have increased rapidly and now represent almost 50% of totalresources. FOGAIN has to pay 8% for Banco de Mexico funds and on averageabout the same interest rate, plus commitment fees, for IDB funds. Since itearns an average of a little less than 8% from intermediaries, its profitshave been declining. During 1974 and 1975 FOGAIN registered losses of about 4million pesos. Following the recent devaluation, losses in 1976 and 1977 areanticipated unless relending rates are substantially increased.

2.10 FOGAIN is the best known and most widely used SMI financing institu-tion. Its volume of lending is substantial, amounting to almost US$100 millionequivalent in 1975. It has many years of experience in working with SMI enter-prises and by operating through the full banking system has achieved a broadnational coverage of regions and subsectors. In recent years FOGAIN hasestablished regional representatives in the provincial offices of NAFINSA, whoare promoting the fund with banks and industrialists and assisting some clientsto prepare loan applications.

2.11 However, FOGAIN's position as a second tier institution also has somedisadvantages. It must depend on commercial banks and financieras to presentcredit applications and does not generally have a close relationship withpotential or existing clients. This has led to some bias in its operationstowards the larger SIII enterprises and has limited FOGAIN's role in technicalassistance.

2.12 In its 22 years of operation until mid-1976, FOGAIN has discountedcredits to approximately 10,700 enterprises, which represents only 14% of thetotal number of SMI enterprises eligible to receive its assistance. Of theassisted enterprises about 6,400 were small (25 or less employees) and 4,300were medium sized. Comparison of these figures with the analysis of the 1970Census indicates that FOGAIN has financed almost 60% of eligible medium sizedenterprises but only 9% of eligible small enterprises. This bias towardsmedium sized enterprises is not intentional on FOGAIN's part, but arisesbecause the intermediaries, who normally carry the credit risks, have severalreas(ns to prefer medium-sized rather than small clients under the prevailingcondiLtions for FOGAIN discounts:

- 114 -

(a) transaction costs are relatively much higher for small loansto small clients, but lending margins are fixed at 3% regard-less of loan size;

(b) it is usually easier to obtain adequate security and collateralfrom medium sized enterprises and FOGAIN's guarantee facilityis not sufficiently attractive to encourage banks to make loansto firms with inadequate collateral;

(c) many of the smaller firms have inadequate accounting systems,which makes it both costly and difficult for them to providethe basic information needed to obtain a FOGAIN discount.Furthermore, some firms are reluctant to deal with a publicsector institution because of fear that information suppliedmay adversely affect their future tax liabilities.

2.13 Being a second tier institution, FOGAIN is not well placed toidentify and provide directly the technical assistance needs of its clients.Although FOGAIN has recently established a Technical Assistance Department,the department is small (3 professionals) and is also involved in promotionalactivities. So far its main achievements have been to produce some shortcourses, illustrated by visual aids to explain the operations of FOGAIN tobanks and potential clients and to introduce basic accounting principles totheir small clients that may need help in preparing loan requests. FOGAINis considering proposals for additional short courses covering accountingand other aspects of management that could be given to groups of clientfirms. More active involvement by FOGAIN in this area has been handicappedby the concentration of its staff in Mexico City and by the fact that its in-come has been barely sufficient to cover its normal operating costs.

Fondo Nacional de Fomento Industrial (FOMIN)

2.14 FOMIN is another trust fund established by the Government andadministered by Nacional Financiera to support SMI. It is a comparativelynew institution which started operations in 1972. Its role is to assist in theestablishment of new enterprises or the expansion of existing enterprises byinvesting up to one third of the total equity capital required. Its investmentis intended to be temporary. Once the assisted company achieves a satisfactoryfinancial position FOMIN's equity participation will be offered for sale toother shareholders, employees or outside investors. Although there are noformal restrictions on the size or type of enterprise that can be supported byFOMIN it is expected to invest mainly in SMI enterprises. Typically, the typeof company requesting assistance from FOMIN is (i) a new enterprise whosesponsors have been unable to raise sufficient equity capital, or (ii) anexisting enterprise undertaking a major expansion that cannot be financedentirely from borrowed funds, or (iii) an existing enterprise that has beenexperiencing financial difficuities and requires a fresh injection of equitycapital to provide a basis for recovery.

- 115 -

2.15 By the end of May 1976, FOMIN had approved investments totallingMex$ 364 million in 142 enterprises, 74 of which were new enterprises, and 30were located in Zone 3. About one quarter of these enterprises intended toexport part of their production. Taking enterprises with a total equitycapital of up to Mex$ 2 million (after FOMIN's investment) as small, and thosewith equity capital between Mex$ 2 million and Mex$ 25 million as medium,36 of the approved investments would be in small enterprises, 99 would be inmedium sized enterprises and 7 in large enterprises. On average, the equitycapital of assisted enterprises would amount to Hex$ 8.5 million after FOMIN'sinvestment.

2.16 Generally there is a significant time lag between the approval andcompletion of an investment, primarily associated with legal processing. As ofMay 31, 1976 FOMIN's total portfolio of completed and still held investmentsamounted to Mex$ 180 million distributed among 70 companies. Of these 26 wereoperating profitably, 23 were making losses and the rpmaining 21 were either inthe installation stage, or had stopped or not yet started operations because oftechnical, financial or legal problems. To date FOMIN has sold part of itsshareholding in 13 companies, of which 10 sales resulted in small profits, onewas at cost and 2 resulted in substantial losses. Overall these sales resultedin a minor net loss of Mex$ 12,000. FOMIN's resources have all be derived inthe form of equity contributions by the Government. Although these resourcesare effectively cost free, FOMIN has not yet achieved sufficient return on itsequity investments to cover its operating costs.

2.17 During its first 4 years of operation, FOMIN has adopted a high riskprofile in its investment decisions. Not only are a high proportion of itsinvestments in new enterprises, mostly in the less developed regions, but ithas also assisted a number of existing enterprises that were already insevere financial difficulties. Although the quality of its portfolio hasgradually been improving, it appears likely to suffer some substantial losseson its present investments. On the other hand, its opportunities to offsetthese losses through dividend income and capital gains are limited by itspolicy of selling its shareholding once a company is operating normally andprofitably and the generally thin market for minority equity holdings in SMIenterprises. Furthermore, because of the substantial manpower costs involvedin selecting, evaluating, processing, supervising and ultimately selling itsinvestments, FOMIN's operating costs per investment are inevitably quite high.Consequently, under present arrangements it is difficult for FOMIN to useany significant proportion of borrowed funds to finance its operations, andthus its expansion prospects are limited by the availability of Governmentequity contributions which are currently severely restricted.

2.18 While FOMIN has provided a useful service in facilitating thecreation of new enterprises and the expansion of certain types of existingSMI enterprises, its sphere of action is somewhat limited, particularly withrespect to investments in small enterprises. So far, FOMIN has only investedin common stock, which means that the enterprise concerned must be structuredas a common stock company (sociedad anonima). M4any small enterprisas are

- 116 -

structured as sole proprietorships or partnerships, l/ which offers certainfiscal and reporting advantages to the entrepreneur. In addition, smallenterprises would often find it uneconomic to have boards of directors and

external auditors and to provide the periodic information as normal1 y requir,d

by FOMIN when investing in common shares. Moreover, there is often somereluctance on the part of the small firm to accept the state as a sharehol,i .Finally, the high transaction costs associated with individual investments

can make small investments uneconomic for FOMIN itself.

2.19 If FOMIN is to expand the scale of its activities and overcome it3

profitability problems it may have to develop new forms of financing that aramore in keeping with its role as a venture capital institution and thecharacteristics of the environment in which it is operating. Venture capital

companies in the US and Canada rarely restrict themselves to investments incommon stock; they normally use a variety of preference shares, quasi-equityloans, variable interest loans, convertible debentures, etc. In addition, suchcompanies often charge some fees for the supervisory and technical assistanceservices they provide. FOMIN's operational scope would be greatly enhancedif it had more flexibility to design a financial package to suit the parti-cular characteristics and needs of its potential clientele.

Fideicomiso de Conjuntos, Pargues y Ciudades Industriales (FIDEIN)

2.20 FIDEIN, another trust fund administered by Nacional Financiera, was

established in 1970 to plan and implement a program of new industrial estatesand industrial cities (estates with housing and commercial zones) at selectedprovincial locations, and thus promote decentralization of industry away fromthe big cities. The role of FIDEIN, in cooperation with the Department ofPublic Works is to prepare the site, provide water, power and other infra-

structure facilities and service needed by industry and then to sell the landin lots to industrial firms who would construct and equip their factories.By mid-1976, 25 locations had been selected for industrial estates and citiesof which 14 were operational. In 9 others work was in progress but theremainder were still in the planning phase.

2.21 So far FIDEIN's progress has been slow in developing and selling the

lots to suitable purchasers and in fostering decentralization and small enter-prise development. Only a small minority of the purchases to date appear tobe genuine cases of decentralization of industries away from the 3 big cities.While FIDEIN has managed to sell many plots in these industrial areas to mediti.i

and large industries, the program has not succeeded in bringing smali indus-tries to take up occupancy on these estates. This is probably becau ee thecosts of the plots (minimum size 1,250 sq. meters at 100 Mex. pesos pcr sq.meter) has proved too high for the small industries, despite arrangements forcredit to be repaid over five years.

1/ See Table 3 of the previous section.

- 117 -

2.22 In an effort to achieve decentralization and support small indus-tries more actively, FIDEIN has recently started to develop a program forestablishing "Conjuntos Industriales" (Industrial Cooperatives), which areessentially conters offering common service facilities to groups of smallenterprises engaged in similar or related industrial activities. These- ;' s -vices mav include facilities such as centralized purchasing orwarehouse services, a design center, extension and advisory services onmanagement and training problems, accounting services, marketing and productexhibition centers and a workshop for machine maintenance. In a few selectedlocations where the idea has been worked out in greater detail and fullydiscussed with the local entrepreneurs, considerable interest has been dis-played in the creation of such Conjuntos Industriales.

Fondo Nacional de Estudios de Preinversion (FONEP)

2.23 Created in 1967, FONEP directly finances preinvestment studies bothfor the public and private sectors. FONEP's financing is on concessionary terms.Loans carry a 10% p.a. interest rate and have a term of three to eight years,with up to two years grace period. By end of 1976, FONEP had approved about230 operations amounting to more than Mex$ 600 million (about US$27 millionequivalent) of which about half was in the industrial sector. In addition topreinvestment studies, FONEP's charter allows it to finance technical assist-ance activities including training of technical staff and hiring of consultants.Although FONEP's technical assistance operations have in the past accounted foronly a minor fraction of its total activities, it is planning to expand theseoperations.

Fondo para el Fomento de Exportaciones de Productos Manufacturados (FOMEX)

2.24 This is a trust fund administered by Banco de 1Aexico for supportingexport oriented industries. It rediscounts commercial bank credit to financethe sales as well as the working capital requirements of the production ofexported and certain import substituting goods. FOMEX also provides guaranteesagainst political risks for the credits.

- llB

III. TECHNICAL ASSISTANCE

3.01 SMI enterprises in Mexico tend to suffer from a wide range of

managerial and technical problems apart from limited access to finance.

Indeed, it is often these other problems that give rise to the need forexternal financing, while reducing the firm's creditworthiness in the eye

of the prospective financing source. These problems tend to be associatedwith enterprise size and the background of the entrepreneur and are not

fundamentally different from those facing small industries in other indus-trialized and semi-industrialized countries. As in other countries, thesmaller enterprises periodically need external technical assistance to help

overcome their particular problems.

3.02 There are a large number of agencies, institutions, trade asso-

ciations and public as well as private consultancies in Mexico that offervarious types of technical assistance to industry. Many of these offervery limited and specialized services (e.g. training computer programmersand secretaries), but there are five main institutions offering servicesthat are relevant to SMI's needs. These are Consejo Nacional de Ciencia y

Tecnologia (CONACYT), Instituto Mexicano de Investigaciones Tecnologicas(IMIT), Centro Nacional de Productividad (CENAPRO), Instituto Mexicano deComercio Exterior (IMCE) and Camara Nacional para Industrias de Transformacion

(CANACINTRA). The following is a brief summary of the activities of thesefive institutions.

3.03 CONACYT has the primary task of formulating and coordinating nationalpolicies for science and technology. It created a technical information ser-vice for industry, which has now been made a separate agency called INFOTEC.Since 1974 it has started to establish some regional advisory centers forindustry on production and technology matters at locations where there are

concentration of particular types of industrial activity. Four such centersare now in operation and more are being considered for establishment. IMITcarries out reserach and develompent work to help improve products and

production processes, and also helps formulate and evaluate industrial invest-ment projects. To date IMIT's clients have mostly been fairly large public

and private enterprises, but it has recently initiated a program to assist a

larger number of medium sized clients. CENAPRO was established in the early

1960s mainly to provide management training courses. Since then it has spreadits activities to include training programs for management personnel of all

levels, vocational training courses (under its ARMO program) for techniciansand skilled workers in diverse areas, and management training and about25,000 workers received vocational training under CENAPRO's programs. While

some of CENAPRO's courses are potentially of benefit to small enterprises, theoverwhelming majority of the course participants have been from medium and

large size enterprises, since they can better afford the codrse fees and

their employees' time away from work. IMCE is a large well-staffed insti-tution that was created to stimulate exports by providing information and

advice to exporters and by organizing trade fairs and promotions. Recently

- 119 -

IMCE has been focussing more attention on the problems of small exporters,and has provided courses on exporting, and helped SMI firms design theirproducts for export requirements and exhibit them at trade fairs. However,despite IMCE's recent efforts, many SMI firms find it difficult to meetvolume and quality requirements of export markets and are unconvinced abouttheir ability to successfully mount an export program. CANACINTRA is thetrade association of which most SMI firms are members. CANACINTRA helps itsmembers with legal and fiscal matters and in dealing with public agenciesand ministries (e.g. to obtain licenses). It also furnishes interestedmembers with lists of technical assistance agencies relevant to their needs,explains their services, and in some cases, provides informal advice onadministrative and financial matters. The regional office of CANACINTRA atCiudad Obregon instituted about three years ago a scheme, under the name ofSociedad de Aval, for guaranteeing loans to small industries and thus helpingthem get the required credit. The scheme operates on a subsidized basis andrequires participating firms to accept technical assistance and continuingclose supervision. The results thus far indicate that the scheme has beensuccessful and CANACINTRA is considering institution of similar schemes atsome of its other regional offices.

3.04 Despite the existence of the institutions listed above, at present,comparatively few SMI enterprises appear to be receiving the assistance theyneed, and this is particularly true of the small enterprises. The reason forthis are several. Many small enterprises are unaware of their managerial andtechnical shortcomings, and at present receive little outside assistance indiagnosing them. Moreover, the small entrepreneur is often unaware of whatsources of assistance are available and anyway has no readily available fundsor sources of credit to finance such assistance. Existing technical assistanceinstitutions direct their attention more to the larger companies and thecontent and cost of their services is often inappropriate to the small enter-prises. Furthermore, most of these institutions concentrate their activitiesin the three largest cities, and are not known to, or easily accessible bySMI enterprises in the provinces. A survey by Nacional Financiera indicatedthat 48X of SMI firms questioned had received no technical assistance fromany source. Of those that had received assistance, 60% had received aid onproduction matters mainly from equipment suppliers, 35% had received someassistance in training their work force and only 10% had received assistancein marketing matters. The proportion receiving assistance in general manage-ment and financial matters was negligible.

- 120 -

IV. THE OVERALL SYSTEM

4.01 It is clear from the above that a basic framework of institutionsalready exists in Mexico that is providing some financial and technicalassistance to SMI. However, it appears that the effectiveness of thisassistance is limited at present and only a relatively small proportion ofSMI (mostly the medium sized firms) are receiving the assistance they need.In recent years, there has been a growing awareness of the economic importanceof SMI, and increasing concern to provide a more comprehensive package ofsupport to such enterprises, which has resulted in several important ini-tiatives on the part of Nacional Financiera, CONACYT and other public insti-tutions. Nevertheless, it is recognized that there is a need for furtherimprovements in the volume, mix and quality of support for SMI.

4.02 During the last two years Nacional Financiera has been carrying outsome studies aimed at developing a better integrated program of supportparticularly for the smaller enterprises. Bank assistance has been soughtfor designing and financing such a program, and Bank staff are now workingwith the Mexican authorities to design such assistance. Based on the NacionalFinanciera's studies, and on the analyses of the mission, it appears that themajor improvements to be considered in developing such a program are asfollows:

(a) Distinguishing the differing characteristics and needs of smalland medium sized enterprises. At present, the SMI definitionsused by many of the institutions providing support are toobroad, since they group together well organized medium sizedcompanies with several hundred workers with small family firmswith four or five employees. This tends to result in a biasin favor of medium sized concerns in terms of access to financeand the design and availability of technical assistance.

(b) Facilitating access to finance for the small firms, many ofwhom have been unable to benefit from existing institutionalmechanisms. This may require FOGAIN to reassess the adequacyof its interest rates, lending margins and guarantee arrange-ments, FOMIN to consider the development of new investmentinstruments, and FIDEIN to develop further its leasing andcommon service schemes.

(c) Filling gaps in the availability of important technicalassistance services. Again this is particularly necessaryfor the smaller enterprises which typically need a broadrange of basic assistance in the production, marketing,administration and accounting areas. Their requirementsare not being met effectively by existing institutions,whose services are often too specialized, too sophisticated

- 121 -

or too expensive. In addition, steps need to be taken toincrease the availability of technical assistance in theprovinces, where the majority of enterprises are comparativelysmall.

(d) Lin_ tF' h the provision of technical assistance more closely tothe provision of financial assistance. The key moment todiagnose the technical assistance needs of SMI firms is whenthe firm is seeking external financing since this is thetime when the entrepreneur is most ready to acknowledge andaccept the need for such assistance. Preferably thisdiagnosis should be made directly or indirectly by theinstitution to whom the credit application is made, whichimplies that banks will need to become involved in thediagnostic process. The public sector and mixed banks canperhaps be convinced to take a lead in this direction.

(e) Improving arrangements for financing technical assistance.While part of the cost of technical assistance may berecoverable from the enterprises assisted, better arrange-ments are needed for spreading the cost of such assistanceover a reasonable period of time and making the costsaffordable by the smaller companies. These may includeone or more of (i) direct financing of part of the over-head cost of the technical assistance system (e.g., exten-sion agents) from public sector sources such as NacionalFinanciera, IMCE, CONACYT, etc., (ii) higher interestrates and increased margins on loans discounted withtrust funds, particularly FOGAIN, (iii) fees chargeddirectly to user SMI enterprises with loans being madeon favorable terms to help spread or defer the costs,(iv) contributions or facilities made available by localbodies, e.g., chambers of commerce, associations ofbankers, etc.

(f) Establishing better mechanisms for coordinating the activi-ties oif the numerous institutions involved in providingdifferent types of assistance to SMI, to ensure that theactivities of these institutions are complementary andrelevant to SMI's needs and that together they provide afully comprehensive package of support. In particular,there is a need to coordinate more closely the provisionof financial and non-financial assistance.

- 122 -

ANNEX V: CAPITAL GOODS

Industrial Projects Department

- 123 -

ABBREVIATIONS AND ACRONYMS

AHMSA Altos Hornos de Mexico S.A.

ALALC Asociacion Latinoamericana de Libre Comercio

CANAME Association of Electrical Equipment Manufacturers

CAPFCE Government Purchasing Agency

CFE Comision Federal de Electricidad

CONACYT National Science and Technology Council

GE General Electric Co.

GE de Mexico General Electrica de Mexico S.A.

IEM Industria Electrica de Mexico S.A.

NAFINSA Nacional Financiera S.A.

PEMEX Petroleos de Mexico S.A.

R&D Research and Development

- 124 -

INTRODUCTION

i. The term "capital goods" as used in Mexico covers primary metalproducts, non-electrical machinery, electrical machinery, and transportequipment. The definition follows the International Standard IndustrialClassification. However, such usage in the context of this paper would beoverly extensive as a basis for planning a development strategy. A morelimited definition of capital goods has, therefore, been chosen, to coveritems of machinery and equipment whose manufacture requires large facilitiesfor fabrication and machining, as well as foundry and forge shops capableof supplying heavy pieces. Included specifically are:

Plant equipment non-electrical power equip-ment, steel-making equipment,chemical industry equipment,sugar industry equipment, etc.

Machine tools metalcutting machines, metal-forming machines

Heavy industrial ) construction equipment, miningmachinery and ) machinery, material handlingequipment ) equipment, etc.

Heavy electrical ) generators, transformers,equipment ) switchgears, large motors, etc.

ii. Throughout this report the term 'capital goods" is used in thislimited sense; wherever the broader ISIC coverage has been referred to inttlis report, i.e., in the review of the entire subsector, the term "engi-neering sector" is used. A major reason for making the distinction interminology relates to transport equipment, specifically the automotiveindustry. The importance of the automotive industry to the Mexican economyis unquestioned. Hlowever, its inclusion in the capital goods grouping woulddistort the position of industrial capital goods manufacture. In export/importanalysis also, the inclusion of auto parts and electrical and electronicconsumer durables would detract from the true picture of industrial capitalgoods.

- 125 -

I. GROWTH, STRUCTURE, AND RELATIVE POSITION OF THE ENGINEERING SECTOR

A. Development Tre ds

1.01 The recent performance of the engineering sector in Mexico isbriefly summarized in Table 1. At constant 1974 prices, the output of thesector grew at an average annual rate of over 12% as compared with about7% for all manufacturing during 1970-74. During the corresponding period,imports of engineering sector products grow at 14.4%, maintaining a 42X-44%share of all manufacturing imports. Exports by the sector improved frombelow 10% of all manufacturing exports in 1970 to almost 20% in 1974, butremained below 5% of the sector's output.

TABLE 1: RECENT PERFORMANCE OF THE ENGINEERING SECTOR IN MEXICO(million pesos at constant 1974 prices)

Gross Value of Production Imports Exports

E M % E M x E M X

1970 61,232 365,258 16.8 16,865 38,964 43.3 1,244 14,228 8.71971 66,210 375,713 17.6 15,395 36,860 41.8 1,718 16,052 10.71972 72,710 406,886 17.9 19,568 44,370 44.1 2,159 18,231 11.81973 84,060 440,058 19.1 23,283 54,259 42.9 3,450 19,603 17.61974 96,740 467,272 20.7 28,077 67,167 41.8 4,343 23,184 18.7

E: Engineering SectorM: All manufacturingSource: Mexico - Una Estrategia para Desarrollar La Industria de Bienes de

Capital, NAFINSA, 1977 (All-manufacturing data from Appendix II, andengineering sector data from Appendix V).

1.02 Table 2 gives the breakdown of production by major sub-sectors. Thecapital goods manufacturing activities fall mainly within the categories ofindustrial machinery and electrical machinery, which together accounted foronly about one-third of the total engineering sector output in 1974. In fact,industrial machinery including light and heavy machinery comprised about 12%of the sector output, and electrical machinery about 20%, compared with 32%for primary metal products and 35% for transport equipment. The relativelystrong performance of the engineering sector during the early seventies wasdue mainly to that of the transport equipment sub-sector (motor vehiclemanufacture).

- 126 -

Table 2: OUTPUT COMPOSITION OF THE ENGINEERING SECTOR(million pesos at constant 1974 prices)

1970 1972 1974Value X Value % Value

Primary Metal Products 20,897 34.1 24,860 34.2 30,640 31.7Industrial Machinery 8,022 13.1 10,220 14.1 11,710 12.1Electrical Machinery 13,444 22.0 15,450 21.2 20,120 20.8Transport Equipment 18,869 30.8 22.180 30.5 34.270 35.4

Total 61,232 100.0 72.710 100.0 96,740 100.0

Source: NAFINSA (1977), Table V-1.

1.03 The slow development of the industrial machinery sub-sector is notunique to the Mexican situation and may be viewed as characteristic of theless industrialized countries. The following table compares the structure ofthe engineering industry in Mexico in 1970 with that of Brazil and Spain, aswell as three leading industrialized countries - West Germany, Japan andthe United States. The Mexican structure is roughly comparable with that inBrazil and Spain, in that industrial machinery output lags considerably behindthe production of transport equipment.

Table 3: COMPARATIVE STRUCTURE OF THE ENGINEERING SECTORIN SELECTED COUNTRIES

(Percent Output)

Industrial Electrical TransportMachinery Equipment Equipment Total

Mexico 21.3 33.0 45.7 100.0Brazil 19.7 28.9 51.4 100.0Spain 22.7 33.7 43.6 100.0FR of Germany 39.3 29.0 31.7 100.0Japan 31.6 35.1 33.3 100.0United States 30.6 28.6 40.9 100.0

Source: "La Industria Metal-Mecanica y los Bienes de Capital en Mexico,"El Mercado de Valores, NAFINSA, 1976.

1.04 Mexico's weakness in industrial machinery production is possiblymost revealing when one considers machines that require relatively highprecision engineering and technology, such as textile machinery and machinetools. Textile machinery is not produced, and the level of machine toolproduction is far below other countries at a comparable stage of industrial-ization. (This industry is examined in some detail in Chapter II).

- 127 -

Table 4: MACHINE TOOL PRODUCTION(in millions of dollars)

1970 1975

Mexico 5.0 4.5Brazil 33.8 137.0Spain 88.6 212.5

Source: Economic Handbook of Machine Tool Industries, U.S.National Machine Tool Builders' Association, 1977.

1.05 Mexico's foreign trade in engineering goods is summarized in Tables5 and 6. Industrial machinery imports comprise the largest category ofengineering goods imports, exceeding 45% of the total in recent years. Thiscontinuing high level of import dependence may be explained in part by theweaknesses within the sector itself and in part by a shift in user demandtowards larger and more sophisticated machinery and equipment that is beyondthe capacity of local manufacturers. The export data in Table 6 excludesexports of assembly plants, which comprise the bulk of Mexico's exports ofindustrial machinery and electrical equipment. Excluding assembly plantproducts, total exports of the engineering sector averaged less than 5% of

the sector's output, with transport equipment (auto components) comprisingthe largest export category.

Table 5: IMPORTS OF ENGINEERING GOODS(million pesos at constant 1974 prices)

1970 1972 1974

Primary metal products 1,162 1,507 1,695Industrial machinery 8,295 8,883 13,452Electrical machinery 2,292 3,961 4,051Transport equipment 5,116 5,217 8,879

Engineering Sector, Total 16.865 19,568 28,077

% of all manufacturingimports 43.3 44.1 41.8

% demand imported 21.9 21.17 23.3

Source: Nafinsa (1977), Table V-6.

- 128 -

Table 6: EXPORTS OF ENGINEERING GOODS /I(million pesos at constant 1974 prices)

1970 1972 1974

Primary metal products 188 360 585Industrial machinery 346 600 1,195Electrical machinery 107 267 553Transport equipment 603 932 2,010

EngineerinR Sector, Total 1,244 2,159 4,343

% of all manufacturing exports 8.7 11.8 18.7

% production exported 2.0 3.0 4.5

/1 Excluding assembly industries.

Source: Nafinsa (1977), Table V-11.

B. Performance of Capital Goods Industries

1.06 General Statistics are not available for capital goods as definedin this report, i.e., for plant equipment, metalworking machinery, other heavyindustrial machinery and equipment, and heavy electrical machinery. However,an indication of the performance of these capital goods industries can beobtained from relevant summary data for "industrial machinery" and "electri-cal machinery" as shown in Tables 7 and 8 below. It should be noted thatconsumer durables are lumped with capital goods in these data.

Table 7: INDUSTRIAL MACHINERY(million pesos at constant 1974 prices)

1970 1974

Production 8,022 11,710Import 8,295 13,452Export /1 346 1,195Domestic Demand /2 15,971 23,967% Demand Imported 51.9 56.1% Production Exported 4.3 10.2

/1 Maquila exports not included

/2 Domestic Demand - Production + Import - Export.

Source: Tables 2, 5, and 6.

- 129 -

Table 8: ELECTRICAL MACHINERY(million pesos at constant 1974 prices)

1970 1974

Production 13,444 20,120Import 2,292 4,051Export /1 107 553Domestic Demand /2 15,629 23,618% Demand Imported 14.7 17.2% Production Exported 0.8 2.7

/1 Maquila exports not included./2 Domestic Demand - Production + Import-Export.

Source: Tables 2, 5, and 6.

1.07 In the industrial machinery subsector, the performance of thesubsector as a whole should give a fairly good indication of the state ofnon-electrical capital goods manufacturing activities in the country. Over90% of the product groups in "industrial machinery" fall broadly within thecapital goods classification, although in the more limited sense of heavymachinery, the percentage would be less. Areas of significant activitiesin Mexico include agricultural machinery and implements, office machines,material handling equipment, pumps and compressors, valves, as well asmachinery and equipment for the mining and petroleum industries. In thissubsector about 50% or more of internal demand was satisfied by imports.Exports increased from under 5% of output in 1970 to around 10% in 1974.

1.08 In the electrical equipment subsector, the production of consumergoods is dominant, and therefore, the overall subsector statistics are lessmeaningful for study of capital goods. The capital gocds segment of thesubsector consists mainly of electrical transmission and distribution equip-ment and electrical industrial apparatus; in 1974, they accounted for under25% of the subsector output. On the other hand, an estimated 70% of theimports were in capital goods. Exports are almost all in consumer products;Table 8 substantially understates these exports because it does not includethe assembly establishments.

1.09 Table 9 compares the import dependence in capital goods amongArgentina, Brazil and Mexico. The figures in the table are imports as per-centages of internal demand. By comparison with Brazil, Mexico imports asubstantially higher share of its needs in metalworking machinery and equip-ment (this category includes machine tools), special industry machineryand equipment (this category includes plant equipment of all types as wellas heavy non-electrical machinery). The product groups in which Mlexico ismore self-sufficient include office machines and domestic appliance.

- 130 -

Table 9: CAPITAL GOODS IMPORTS(as percent of internal demand)

Argentina Brazil Mexico1970 1973 1970 1973 1970 1972 1974

Industrial Machinery 34.6 19.4 26.6 29.7 44.7 41.8 48.7

Metal & wood workingmachinery & equipment n.a. n.a. 18.0 26.7 85.1 79.5 87.2

Special industrymachinery & equipment n.a. n.a. 47.7 46.1 89.0 89.0 93.8

Agricultural machinery& implements 7.2 2.5 14.4 43.8 33.6 25.6 29.9

Office machines n.a. n.a. 57.6 65.7 34.8 36.4 42.3

Electrical Machinery 17.2 18.0 14.1 17.2 14.7 20.2 17.1

Industrial machinery& equipment 28.8 33.7 4.0 9.8 23.8 28.3 24.6

Ratio, TV and commu-nication apparatus 12.6 9.5 15.5 18.3 16.5 25.7 20.9

Domestic appliances 7.3 2.5 4.0 4.4 1.8 2.1 2.6

Total, EngineeringGoods 14.4 9.9 15.8 15.8 21.2 20.9 22.6

Source: Nafinsa (1977), Table III-35.

1.10 The capital goods sector in Mexico is considerably less developedthan in some other comparable countries; and the kinds of goods that areproduced seem to be poorly related to Mexico's likely comparative advantage.Several reasons have contributed to the relatively low level of developmentof the sector. The relatively low level of protection of the industrydeserves mention. Government agencies and the private sector have, ingeneral, found it easy to import capital equipment; and the lack of creditfacilities for Mexican producers which could place them in a position tocompete with foreign suppliers imposed another important constraint. Inparticular, the preferential access of government agencies to imports hasdrastically reduced the domestic market for capital equipment, much of whichMexico could probably produce fairly efficiently itself.

1.11 The production of intermediate inputs such as castings is par-ticularly poorly developed and a significant cause for the high cost of final

-131 -

products. Since the manufacture of intermediate inputs is frequently labor-intensive, it could be used as an important vehicle to establishing costadvantages in the capital goods field.

C. General Strategic Considerations - Capital Goods Sector

1.12 For efficient planning it would be necessary to determine a devel-opment strategy that would be most advantageous to Mexico. The relevant workwould have to be designed around selected priority product lines, with spe-cial emphasis on the development of necessary infrastructure and indigenoustechnological capabilities.

1.13 Development planning for the capital goods sector should startwith a careful identification of the major manufacturing linkages, so thatappropriate plans can be formulated not only for the end products to bemanufactured but also for the less apparent supporting industrial develop-ment. Starting with the end product groups that have been identified fordevelopment attention in Mexico, the progression of manufacture from rawmaterials to final assembly is indicated in Table 10 to illustrate the majorsupporting industrial development that must accompany the decision to manu-facture these end products. In the table, no attempt has been made to listall the important items of manufacture or to show the major linkages. Ob-viously, for actual planning a much more comprehensive table would have tobe prepared, down to specifying the representative types and sizes of itemsto be considered for local manufacture.

1.14 Each element in the table can be thought of as representing a po-tential singular industry receiving goods from those industries on its leftand shipping goods to the industries on its right. Such an organization isconceptually feasible, but in practice, the degree of linkage or integrationwill be determined at the project identification and appraisal stages.

1.15 The key to establishing comparative advantage in machinery manu-facture lies with the items listed under the column heading of primarycapabilities and components. They comprise the basic building blocks of thesector in that they dictate the quality and cost of downstream products fromintermediate to end items. For a country like Mexico, the foundry industrymight be singled out for priority development attention because here theadvantages have been shifting from the highly developed countries to theindustrially less advanced countries as a result of rising labor costs andstricter environmental regulaticns in the former.

1.16 The manufacture of primary components such as machine bearings andgears is usually subject to market constraints in a developing country. Somesimpler types might be produced, but there are endles varieties as to designs,sizes and precision. They are typically made in the industrialized countriesin quantity, using costly production machines that are difficult to Justifyfor a small market. For these, while some measure of protection should begiven to domestic producers, over-protection in the form of an indiscriminatebanning of imports can needlessly add to the production problems and costs of

Table 10: CAPITAL GOODS INDUSTRIES

Primary Intermediate Main UserRaw Materials Capabilities Components Items End-Products Industries

Steel & Alloy Steels Casting Fasteners Structurals Machine Tools Chemicals

Non-Ferrous Metals Forging Bearings Heat Exchangers Mining Machinery Petro-Chemicals

Fouodry Pig Iron, Fabrication Gears Engines Material Handling Equip. Petroleumetc.

Machining Cutting Tools Pumps & Compressors Electrical Machinery Mechanicaletc.

Heat-Treatment Motors Oil Field Equipment Electric Power U

Stamping Driveline Sub- Chemical Plant Equipment MiningAssemblies

Gear Reducers Food Processing Equip. Metallurgical

Hydraulic Systems Sugar Mill Equipment Foodetc.

Control Systems etc.

- 133 -

down-stream machinery makers. In Mexico, while a variety of primary compo-nents can be locally supplied, the supply capability as to product qualityand precision appears highly limited.

1.17 The i .iety and sophistication of intermediate items made in acountry is pz;bably the best indicator of its level of machinery manufac-turing capability. In Mexico, the intermediate goods sector appears bestdeveloped in conjunction with the manufacture of chemical plant equipment(boilers, heat exchangers, pumps and compressors) and motor vehicles, andleast developed in the area of industrial machinery manufacture.

1.18 The end-product maker, at one extreme, could have an assembly-onlyoperation; and at the other extreme, an end-product maker could make in-plantalmost all the items he needs. The latter type is often necessary in adeveloping economy such as Mexico, because of a weak supplier base; but asthe requirements in machinery manufacture for specialized parts are variedand in small quantities, production may often not be feasible from standpointsof cost and quality. Assembly operations would also be high cost, sinceparts must be imported largely in finished form and in small quantities. Thebasic issue underlying either type of operation is that uniform standardscannot be set for the industry. Each plant may work from its own set ofspecifications. In any event, lack of standardization complicates theproblems of substitution of domestic parts for imports and constitutes aserious problem in the development of domestic supply.

1.19 The recent devaluations and business slowdown have generated a cli-mate of uncertainty within the Mexican industrial sector, with manufacturersfacing material and labor cost increases, as well as a sharp increase ofthe peso value of any foreign debt burden. Nevertheless, future prospects forthe capital goods sector of Mexico should be rated as good on account of thegrowing capability of the steel and energy industries, which are importantingredients for heavy industries. It should be noted, however, that while theapparent demand for capital goods may seem large on account of the projectedinvestments in the major user industries (oil, chemicals, sugar, electricpower, etc.), the actual demand will be highly diverse as to type and sizeof equipment. Also, the international trend towards capital equipment ofincreasingly large capacity signifies that more exacting designs and produc-tion processes will be required.

1.20 Efforts to accomplish a high percentage of import substitution canonly result in a lengthy shopping list of projects that will not likely prove

- 134 -

too meaningful for the country. 1/ In fact, the domestic market should notbe the sole or even the major criterion in the determination of developmentpriorites, since eventual export competitiveness is both necessary for effi-cient development of the sector, and probably achievable in many productlines. Thus, development priorities in capital goods should be based on whatcan be produced efficiently and competitively, taking into account matters ofproduction scale, technologies, skills as well as opportunities for simulta-neous development of the supplier industries.

1.21 The Government's decision to promote capital goods manufactureappears to have been made only recently, and neither the government agenciesnor the industries concerned apparently have had the opportunity to fullyassess the implications, the opportunities and the problems. The capitalgoods sector in Mexico is too small to turn around on its own. A compre-hensive program of government support, in the form of development strategyand financial incentives would be essential. The promotion of capital goodsproduction could, in addition, be assisted by (a) provision of an adequaterediscounting facility that would enable Mexican capital goods producers tofinance sales (both domestic and export) on internationally competitive terms;(b) ending preferential access of public sector enterprises to importedequipment; (c) ending or restricting the coverage of the import licensingsystem so as to encourage efficient specialization, scales of production, andquality improvement and price competitiveness; (d) government promotion ofresearch and development efforts and better quality control; and (e) encourage-ment of foreign participation, especially in high-technology end products.

1.22 Four industries are examined in greater detail in the followingsections: the foundry industry which provides inputs to a wide variety ofproducts; the machine tool industry, which is one of the better indicatorsof the level of manufacturing sophistication achieved by a country; metalfabrication, which includes many labor-intensive special order goods; andheavy electrical equipment, which supplies goods mainly for public enterprises.

1/ A recent series of ITNIDO studies for NAFINSA identified over a dozenprojects, with emphasis on electrical machinery, for early implemen-tation in the capital goods sector. They were based mainly on roughestimates of domestic market growth through the Eighties. No strategicplanning appears to have been done with regard to the relative develop-ment priorities within the capital goods sector, the development of thesupply infrastructure or the factors of comparative advantages in localmanufacture. It is suggested that the need still exists for a morebasic approach to the development planning of the capital goods sector.

- 135 -

II. HEAVY INDUSTRIAL MACHINERY AND EQUIPMENT

A. Profile of the Industry

2.01 This section discusses the manufacture of fabricated plant equipmentincluding such equipment categories as (i) boilers, heat exchangers, pressurevessels and other similar equipment; (ii) machinery for the food industry;(iii) drilling rigs, well head and other oil field equipment; and (iv) plantauxiliary equipment (pumps, compressors, etc.). In this heavy machinery andequipment area, manufacturing capabilities are comparatively well developedin Mexico. Particularly for smaller and simpler types, the domestic contentof output may range between 60 and 90% by value.

2.02 Also included in this section is a detailed review of the foundryindustry and the machine-tool industry because of their important role assupporting industries. Both industries face considerable structural weak-nesses and operational deficiencies which need to be overcome if the devel-opment opportunities of the Mexican capital goods sector are to be exploitedmore fully.

2.03 Heavy equipment manufacturing in Mexico developed principally toserve resource-based industries such as mining, sugar and petroleum. Theproducts involved have many common characteristics. They are large, weighingin many cases several tons; their production does not require complex produc-tion processes, or particularly high precision engineering, as machine toolsor textile machinery do. However, high reliability and safety requirementsdemand skills in engineering design and metal fabrication. Production isoften of the one-of-a-kind type and almost always limited to a small numberof a single design or size.

2.04 The majority of the plants in the sub-sector was established in theperiod from the mid-1950's to the mid-1960's. Many of the plants grew out ofthe sales operations of US-based transnational firms, and were often equippedwith used but serviceable equipment of the parent company. Such equipment(much of which is still in evidence) is now anywhere from 15 to 30 years oldand does not represent the "current state of the art" in manufacturing tech-nology. However, almost all the companies have also added modern machinesin the early 1970's, including machine tools, heat treating facilities, lab-oratory equipment and computers. In several plants, there is also turningand milling equipment with numerical controls.

2.05 The following table summarizes the activities of some of the plantsvisited by the mission.

Table 11. PROFILE OF REPRESENTATIVE PIANT EQ:)IPHENT MAKERS IN MEXICO

Zmestic Capacity Percant LocalType of Market Share Utilization Ccntent Arhieved

tMaNv Venture & -I. Product Line X X _ Pre devaluaticn) Rerks

Atlas Copo sIx Mexican Air Compressor 25 70 80 Main problem is declining orders from mining industry; negligable e-qxirt.

Injersoll RaidL U. S. Puw6s, Conpressors 25 ne C0-9G InpDrts include fully - 'ined forgings; plan for nev plant postponed; no export.

Mbrthingi n S1S Mexi can Puns, (Ompressors S 80 80-90 New plant est. early 1970's; makes most products made by parent ccyimy in U. S.

acock & WloDx U. Y. Industrial boilers & Supplies boilers to Pemeex. sugar nulls, etc: no export, expasion ramutility boile:s to 100 mv 50 50 70 postponed.

I FAt-^FSA MexIcan Chemical plant equipnent na 50 50-80 Plant est. 1973. needs additional chinery but financially constrnined; onlymaker ofoentrifuges for sugar indsmtry; no export.

Industria dei dierro Mexican Heavy fabricated items jobing 60 60-80 Possibly largest heavy jobbing plant in country: all castLngs and forgingsoperation rcured fran outsice supliers.Conjunto Mexican Oil drilling rigs 30 below 50 60-70 Pemex is only custaoer; main prvblem is working capital.

LA)EPN-Gray S1X MexIcan Oil well-head equipment 30 80 60-90 Plans new facilities: existing plant is old and crvaded; exports aiout lQS of csutpt

FIPSA MPexican Well-head equip. & valves 40 na 70-90 Fbrgings supplied to outside custaoers; no export.

Refaccionaria de Mcdinas Mexican Flour & rice mill. mach. drninant 75 90 Started over 30 years ago as spare parts susplier for milling equiieant; export1/3 of output; main problem is export credit finarcing.

Swe(anx Mexican Heat exchangers 30 50 70-80 Supplies heat exchangers to Paeex. CTE etc. No export.

Allis Chalmers 51X Mexican Material handling equip. 35 50 80 Inports DC mators and hydraulic units: sane sall export.

FMC-Link aelt U. S. Bulk handling equip. 20 100 80-90 Serves mining caenent, sugar industries: negligible export.

Mecanlca Falk 51X Mexican Gear reduction units 70 80 80 Plant is dominant maker of industrial gears: order badclogs don.

Joy Manufacturing U. S. Bakery equipment dominant 50 90 Also nakes pollution control equipmnt; export abot S-IOX of output.

FAMA Mexican Glass noulding mach. doninant 80 70 Exports about 20Q of output.

Source: Inforaation gathered by the mission

- 137 -

2.06 The plants included in Table 11 are among the larger and more effi-cient units within the sub-sector, as their domestic market shares suggest.They are all in the private sector; also, the extent of Mexicanization ofownership is evident. Under the business conditions which prevailed duringthe latter part of 1976, capacity utilization was generally low. Averagecapv'ity util Lacion for the sub-sector was estimated at below 50% of whatcould be achieved with a full work force employed in two shifts. Particularlyhard hit were those manufacturers that depend directly or indirectly uponorders from public sector organizations such as Pemex and CFE. There hasalso been a more subtle constraint to market growth. Most of the equipmentof the type made by the sub-sector has until recently been procured fromindustrialized countries. Hence buyers still have to be convinced thatproducts made by domestic firms are equally good, equally reliable, andequally well covered by a competent service organization, as the foreignsuppliers on whom they depended in the past.

B. Problems and Constraints

Raw Materials and Parts

2.07 The basic material inputs of the sub-sector are: steel plate, steelbars and profiles, iron and steel castings, steel forgings and steel (includ-ing alloy steel) tubes. With respect to steel plate and rolled steel shapes,the existing Mexican mills are capable of supplying the needs, except forunusually heavy or unusually large steel plate. Most of the more commonalloy steels (in the form of bars) are also available from local suppliers.There was some concern in the industry, however, that some steel specifica-tions, and some less frequently used sizes, are made by the mills only whenorders on hand are sufficiently large to justify a special "run". This wassaid to have caused problems at times, due to the unavailability of importlicenses for materials on the prohibited list; and firms have to keep overlylarge stock of seldom used materials on hand.

2.08 Iron and steel castings are usually available from local foundries,although often of less than satisfactory quality and relatively high priced.For example, castings for pumps and compressors have porosity problems which,on average, result in the rejection of over 10 percent of the castings.Forgings are even more problematical. Evidently, there exists-insufficientforging capacity in the country, particularly for pieces requiring drop-rather than hammer-forging. Prices were reported as substantially higherthan in the United States. Carbon steel tubes (used in large quantities forboilers and heat exchangers) are readily available from Mexican sources.however, tubes made of alloy steel, needed in special applications, must beimported.

Production Costs

2.09 Before the devaluations, prices of local plant equipment and auxi-liaries were reported as being on the average about 20% to 30% above worldprices or the prices of parent companies in the United States. This wasexplained not only by the prevailing low capacity utilization but also the

- 138 -

use of old equipment and the poor quality of local cutting tools and abra-sives. The poor quality of cutting tools and abrasives is an often repeatedcomplaint, which is rather surprising in view of the presence in Mexico ofsuch makers as Sandvik, Norton and Carborundum. A possible cause is thesub-standard quality of certain local inputs, e.g., binders used in grindingwheels. The persistence of such problems has added to the production prob-lems and costs of the capital goods industries. In addition, the interna-tional trend towards plant equipment of increasingly larger capacity andhigher efficiency demand more exacting designs and manufacturing skills,further reducing the ability of local producers to compete internationally.

2.10 Prices and costs were in a state of flux during the mission visit.Following the first devaluation of September 1976, prices of capital goodsincreased on the average by 20% to 30%. The cost of imported inputs, and ofmany domestic inputs as well, increased by more than the full amount of thedevaluation, and further increases in prices can be expected until somebalance is reached between costs and prices. Thus, the net effect of thedevaluations would appear to have been at best a very modest improvement inthe competitiveness of this sub-sector in world markets.

2.11 Most of the companies in the sub-sector have very little exportbusiness. Some have in the past filled a few export orders channeled tothem by their foreign parent companies or technical assistance partners.Generally, however, the companies are not export-oriented. There are a fewnotable exceptions. These are firms with indigenously developed technology.For example, the major manufacturer of grain and rice milling equipment inMexico (Refaccionaria de Molinas) has developed its own line of equipmentwhich apparently rates at par with the world's best makes. The firm hasbeen exporting about one-third of its output. Another case is the Fabri-cacion de Maquinas enterprise at Monterrey which makes and exports glassmoulding machinery and glass moulds.

Technology

2.12 Industrial technology is an important and integral element of thecapital goods establishment. In Mexico, the approach to technologicaldevelopment appears to have been to leave the responsibility for R&D effortsto the industrial firms. The government's role is largely confined to theregulation of technology transfers into the country. This was probablyappropriate as long as foreign-owned firms dominated the industrial scene,as these firms would have had access to the technological resources of theirparent organizations. However, with the Mexicanization of industrial owner-ship, the lack of any independent indigenous technological capability repre-sents a critical weakness in the manufacture of capital goods. To date,there appears to be no organization in Mexico capable of serving the needsof the basic industries, similar to the National Institute for IndustrialTechnology (INTI) of Argentina, the Institute for Technological Research(IPT) of Brazil, the Council of Scientific and Industrial Research (CSIR)of India or the Korean Institute of Science and Technology (KIST). TheNational Science and Technology Council (CONACYT) in Mexico is in charge of

- 139 -

"coordinating" scientific and technological activities in the country, butit neither funds nor conducts research, nor has it any other direct role inmeeting the technological needs of industries.

2.13 At the plant level, with very few exceptions, the sub-sector relieson foreign inventions, research and development. While many companies employengineers, these men are invariably production engineers; they are concernedwith plant layout, work handling etc.; but very few work on product design ordevelopment. A small number of firms has moved into the stage of product de-sign adaptation, attempting to make (usually rather minor) changes in productcomponents with a view to permit local sourcing, machining with equipmentavailable in the plant, or reducing costs. There are, of course, good reasonswhy an enterprise, whose objective is the making and selling of a product ata profit, will refrain from trying to "re-invent the wheel", and will obtainthe technological information needed for its business through licensing orperhaps through adaptation of someone else's product. From a national view-point, and considering the long-range implications, however, this approachleaves much to be desired, especially when there is no corresponding R&Dactivity to expand on the acquired knowledge. It is well recognized that adesign which was developed as an optimal solution in a particular environmentmay not be optimal in a different environment. The scale of production, theavailable manufacturing equipment, the availability and cost of materials,as well as the relative cost of labor vs. capital, all are inputs which acompetent designer will consider before completing an engineering design.Obviously, the conditions in the United States (where most of the Mexicanproduct designs originate) differ greatly from those in Mexico. The resultis, unavoidably, that products cost more, and in some cases are only imper-fectly suited to their eventual uses.

2.14 Similar deficiencies exist relative to standards and standardiza-tion. While CONACYT has coordinated a number of consultative bodies onstandards, relatively little progress appears to have been achieved in termsof acceptance of standards at production level. If Mexico is to improve itsefficiency as an industrial producer, greater attention must be given to theissues of industrial research and standardization.

Finance

2.15 Without exception, manufacturers regard financial difficulties astheir most pressing problem. This situation has different causes:

- The business slump which prevailed during much of 1976reduced earnings, while fixed costs kept growing ;

- the government customers, who constitute the most im-portant buyers of capital goods, have been slow in thesettlement of their accounts;

- direct costs, both for labor and materials, have risenrepeatedly during recent years, and particularly in thelast few months; and

- 140 -

- for some companies - particularly for those which mustrepay large foreign currency loans or those whose productsrequire considerable payments of foreign currency (mate-rials or royalties) - the recent devaluations have causedmajor linuidity problmes.

C. Foundry Industry

2.16 According to a recent survey published by NAFINSA, total foundrycapacity in Mexico is estimated at 570,000 tons per year, of which 470,000tons per year are iron foundry capacities. The steel foundries produce mainlyplant machinery and equipment and railroad castings (wheels, couplings,etc.). The iron foundries largely produce auto industry items. Almost 50%of the iron foundry capacity is captive to the auto industry, and many of theindependent foundries also produce automotive products. The balance of theiron foundry capacity is divided between industrial items such as machineryparts and non-industrial items such as pipes and fittings. The foundriesin the small-scale sector are all gray iron foundries producing low-valuecastings for industrial and agricultural use, for example, pump housings,farm implements, and auto parts for the repair and replacement market.

2.17 Castings are primary products made by independent, generally small-scale foundries, as well as by equipment manufacturers. The latter do so tomeet their own requirements. As almost no statistics are kept on the per-formance of the small-scale sector, reliable industry-wide information isdifficult to compile. The following two tables give only an approximateprofile of the foundry industry in Mexico.

Table 12: Status of Foundry Industry

No. of CapacityEstablishments Employment 1000 tons

Iron Foundries

Large units(over 5000 t/y) 14 /,500 250

Medium units(1000-5000 t/y) 30 3,500 70

Small units(all grey iron) 400 19,000 150

Steel Foundries 30 3,000 100

Total 474 33,000 570

Source: Asesoria Tecnica Industrial, Mexico, 1975.

NAFINSA, 1976

- 141. -

Table 13: ReDresentative Major Foundries

CapacitySteel Iron Main Products

Fundiciones de Hierro y Acero 34,300 7,800 Railroad castings andautomotive products

Siderurgica Nacional 18,300 15,000 Casting for steel andauto industries

Fundicion de Acero Tepeyac 12,000 4,800 Industrial equipment parts

Fabricacion de Maquinas 18,000 of " o

Campos Hermanos 27,000 Industrial and auto castings

CIFUNSA 44,400 Castings for auto industry

Ford 20,000 " " "

General Motors 20,000 " to

Fundicion Monclova 36,000 Industrial and auto castings

Talleres Universales 11,700 " It of

Talleres Industriales 12,000 Non Industrial castings

Fundiciones Ruiz 12,000 " " "

AMSA 18,000 Castings for auto industry

Acero Solar 4,000 Alloy steel castings

Total 68,600 246,700

Source: NAFINSA, 1976

- 142 -

2.18 Rough production figures suggest that the output of the foundryindustry has declined since 1974:

(1000 metric tons)

1973 1974 1975 1976 (estimated)

Iron Foundries 240 310 290 under 200

AutomotiveFoundries only 120 150 110 under 100

Steel Foundries 75 n.a. n.a. 50

Small-scale Sector 100 100 100 under 100

Source: NAFINSA, 1976

The average capacity utilization rate peaked in 1974 at about 70% - 75%, andis estimated to have fallen below 50% in 1976. The drop is attributed mainlyto cutbacks in procurement by the national railways and other governmententerprises as well as a general slow-down of economic activity in 1976.Imports of castings have remained relatively constant at between 10-15,000tons per year since about 1970; they comprise mainly machinery parts importedfor domestic assembly operations. The comparatively low and constant levelof these imports is mainly the result of the depressed level of productionactivity in the machinery sector itself.

2.19 The foundries in Mexico range from a few modern to many primitivefacilities, with the better foundries almost all linked to the automotiveindustry. The auto foundries are by and large production-type foundries,designed for the efficient production of specific items such as engine blocks.The facilities do not allow for production of items other than those forwhich they were originally intended. Outside the automotive sector, thereappear to be only a small number of foundries capable of producing industrial-grade castings of requisite grade, and they have a virtual market monopoly.Before the 1976 devaluations, these foundries typically had order backlogs of6 to 8 months. Thus, even under the present relatively depressed state ofthe machinery industries, the end-product manufacturers appear to have beenconstrained by difficulties of local procurement of quality castings. Thefirst important development issue for the foundry industry is therefore notsimply an increase in the total tonnage capacity, but a selective upgradingand expansion of capacities that will serve industrial machinery manufactureof high priority and promise for the country.

2.20 The second issue is cost. Foundry operations are usually labor-intensive, especially in the jobbing operations, and countries with lowlabor costs should have a cost advantage. However, prices of iron and steel

- 143 -

castings in Mexico before the 1976 devaluations were significantly abovethose prevailing in the United States; even after the devaluations, pricesremained roughly comparable to US prices (machine-grade iron castings cost.45 to .55 per lb. in the United States). This is certainly not a satis-factory situation for Mexico, as US prices are high by world standards,and countries like Mexico should be able to supply castings at lower prices.The cost factors are discussed in more detail further below.

Steel Foundries

2.21 There are about 30 steel foundries in the country with an installedcapacity of about 100,000 tons per year. The major markets for steel cast-ings in Mexico are railroad equipment, and plant machinery parts for suchindustries as steel, sugar, heavy electrical equipment, mining and cement.The largest pieces range up to about 20 tons. The capacity utilization inthis sub-sector is estimated at below 50% in 1976. Two top-rated foundriesoperated at 100% of capacity, working mainly on order backlogs, but neworders seem to have declined substantially in the latter part of 1976 evenin these cases.

End-use Distribution of Steel Castings

Percent

Railways 35.0Metallurgical industries 30.0Machinery industries 20.0Others 15.0

Total 100.0

2.22 Steel castings are produced by melting steel scrap in electricarc or induction furnaces. The largest non-labor cost components are scrapand electric power. Mild steel scrap is partly procured locally and partlyimported from the United States. The imported scrap is obtained in compactedform, but the local scrap is mostly loose and rusty. The poor condition ofscrap can increase the melting time and reduce the efficiency of the electricfurnace, the most expensive piece of equipment in the plant. In fact, theelectricity consumption in the foundries visited, which presumably are thebetter units, is reported to be as high as 1000 kwh per ton of liquid steel,as compared with the international norm of 600 to 700 kwh. Closer attentionto the quality of scrap supply would be necessary. In particular, improvedsorting and compacting of scrap would be beneficial. For alloy steel cast-ings, ferro-chrome, ferro-silicon and ferro-manganese are all locally avail-able. Nickel, tungsten, vanadium, cobalt, etc. are, however, imported frominternational sources.

2.23 Before the 1976 devaluations, ordinary steel castings in Mexicocost on the average 25 pesos per kilogram, with some high-alloy castings

- 144 -

costing over 100 pesos/kg. Price increases after the first devaluationin September 1976 were relatively modest, about 20%, but may have gone upfurther since.

2.24 The cost structure for two representative cast steel items isgiven below:

SAMPLE ASteel valve - 100 kilogram net weight

Percent

Ex-factory price 100.0Total mat. rial and transformation cost 58.0

Mater.ial costScrap (222 kg) 26.0Return to scrap (122 kg) 11.0Net scrap cost 15.0Sand, mould, core 4.0Total material cost 19.0

Transformation costFuel and electricity 13.0Labor 26.0Total transformation cost 39.0

SAMPLE BHeavy machinery casting

Percent

Ex-factory price 100.0Total material and transformation cost 63.0

Material costNet scrap cost 26.0Sand, mould, core 3.0Total material cost 29.0

Transformation costFuel and electricity 12.0Labor 22.0Total transformation cost 34.0

2.25 Before the 1976 devaluations, the ex-factory prices of cast steelmachinery parts in Mexico may be estimated at roughly 50% above internationa'prices. The material cost was about 20% higher. Reasons were higher pricespaid for raw materials as well as higher consumption of materials per unit ooutput. The potential labor cost advantage was largely lost because of low

- 145 -

production efficiency. Mexican foundries are reported to average between60-70 man-hours per ton of output, but if the more efficient automotivefoundries are factored out, the actual figure is estimated to exceed 100man-hours per ton, as compared with about 40 man-hours per ton in theUnited States.

2.2b Since the devaluations, the prices of Mexican castings wouldappear to be more in line with prices prevailing in the US, but it couldwell be only a transient improvement unless steps are taken to resolve thebasic high-cost factors.

Iron Foundries

2.27 There are over 400 iron foundries in the country, but an estimated90% of them are in the small-scale sector. Total output exceeded 400,000tons in 1974, including roughly 100,000 tons produced by the small foundries.Production has since declined to below 300,000 tons in 1976. Four out of thefive largest iron foundries in the country are automotive foundries. Sincemany of the independent foundries also produce auto parts, it is estimatedthat 60%-70% of the total output of the iron foundries is linked to motorvehicle manufacture and repair. Industrial castings, excluding automotiveproducts, comprise less than 10% of the production in Mexico. This smallsegment comprises the iron foundry base supporting capital goods manufacture.It is thus substantially smaller than the foundry production for non-indus-trial castings (manhole covers, pipes, pipe flanges) the share of which intotal iron foundry output is well over 20%.

2.28 The end-use distribution of industrial castings is shown below:

End-use Distribution of Industrial CastingsExcepting Automotive Castings

PercentSmall Tools and Implements 10.0Pumps and Compressors 5.0Diesel Engines 15.0Sugar Plant Equipment 20.0Paper Plant Equipment 15.0Cement Plant Equipment 10.0Others 25.0

Total 100.0

The product range is largely limited to the smaller and less sophisticatedend of the plant equipment market. It reflects both the limited capacityand capability of the foundry industry itself and the lack of development ofthe downstream machinery industries in Mexico. By contrast, in the advancedcountries high-grade machinery castings (machine tools, textile machinery,etc.) may comprise up to 50% of the production of industrial castings.

- 146 -

2.29 The major raw materials required for production of iron castingsare pig iron, scrap and coke. In the industrialized countries, foundry-gradepig iron (which has a higher silicon content than basic iron for steelmaking)is readily available in several grades with prescribed chemical compositionto meet the requirements of different classes of castings. In Mexico, suchpig iron is not available and scrap is used almost exclusively to make ironcastings. Since scrap quality is variable, the cupola charges have to beconstantly analyzed and juggled, an expensive proposition that requiresskilled manpower and expensive equipment beyond the resources of the smallerfoundries. This is believed to be a major reason for the inconsistent qual-ity of local castings as well as excessive casting defects.

2.30 Poor quality of Mexican coke is also a problem. The ash content isreported to be well above the maximum 10% level of efficient cupola operation.The large iron foundries, including the automotive foundries, have bypassedthe problems of materials supply by using the more costly and capital inten-sive electric furnaces; but this practice is beyond the means of the smalland medium size iron foundries, which are limited to the production of low-value castings. This explains the somewhat paradoxical situation in Mexicothat there is considerable foundry capacity in the country that is not fullyutilized, while it has remained difficult to procure suitable castings formachinery manufacture.

2.31 Before the 1976 devaluations, the ex-factory prices of iron cast-ings averaged about 12 pesos per kilogram for general castings and 15-17pesos per kilogram for better-grade castings. By comparison, machine-gradecastings in the United States cost .45 to .55 per pound (12 to 15 pesos perkilogram, pre-devaluation). The actual price difference would be largerthan that shown by these figures, as the US product would generally be ofbetter quality and precision that the "better-grade castings" in Mexico. Aswas discussed earlier in the section on steel castings, the Mexican costs arehigh because more material and labor are required per unit of output. Fol-lowing the first devaluation in September 1976, the price of iron castingsincreased by about 20%. At the exchange rate of about 20 pesos to thedollar, the price of iron castings in Mexico would be roughly equal to thelowest US price for machine castings; but further lowering of prices shouldbe possible through rationalization and selective upgrading of existingproduction facilities.

2.32 To achieve this objective, adequate supplies of pig iron, gradedand compressed scrap, and higher quality coke are essential. No foundry willinvest in modernizing facilities or improving production methods uniless it isassured of proper raw material supplies that will enable it to upg-ade itsproduct lines; but this move to higher quality castings may be indispensablefor further growth, as the market for low-grade castings appears crowded andis not expected to grow much larger. Future growth opportunities of thefoundry industry are likely to emerge largely in machinery castings (high-grade precision castings), for which a growing domestic demand and exportopportunities as well can be anticipated. Foundry industries in the US andother advanced countries face rising labor costs and stricter environmental

- 147 -

standards. If Mexico can solve the problems of casting quality and cost,

it could become an impUttant supplier of industrial castings to the UnitedStates and other countries.

D. Machine Tool Industry

General

2.33 Mexico ranks high among the world's large machine tool consuming

nations. In 1975, the domestic demand totalled US$244.5 million, which

placed the country ahead of Brazil and only behind Spain among developing

countries:

Leading Machine Tool Consuming Nations

1975Value

(Million US dollars) Ranking

United States 2285.1 1USSR 2284.4 2

Japan 930.7 3FR of Germany 755.5 4France 716.7 5

Spain 274.8 10Mexico 244.5 12Brazil 206.0 14

Source: American Yachinist (McGraw-Hill Inc.).

2.34 Contrasted with the large home demand for machine tools, Mexicostands unique among the more advanced industrializing countries in its almosttotal reliance on imports. Table 14 compares the recent trend in Mexicanmachine tool production and trade with four other countries - Spain, Brazil,India and Argentina. Between 1970 and 1975, production of machine tools,covering all types of metal cutting and metal forming machines, more thandoubled in Spain and tripled in Brazil and India. Production in Argentina

increased by about 20% from $33.4 million in 1970 to $42.0 million in 1975.

Production of machine tools in Mexico, by contrast, remained stagnant below

$5 million. If one takes into account the price increases of machine toolsbetween 1970 and 1975, machine tool production in Mexico actually declined

from the already low level of $5.0 million in 1970.

Table e, Machine Tool Production and Trade of Selected Countries

(million U.S. dollars at current prioes)

1975 (estinated) 1974 1970Percent Deumad Percent Derend Perczent Demarid

Production Export Invort imported Production EXport Imnot TMinP x=1 prt LmiIt DIen I tnr:td

Spain 212.5 81.4 143.8 274.9 52.3 207.0 68.5 128.5 267.0 48.1 88.6 29.5 56.2 115.3 48.7

Brazil 137.0 14.0 83.0 206.0 40.3 111.3 6.0 70.5 175.8 40.1 33.8 4.6 34.6 63.8 54.2

India 96.0 11.2 29.6 114.4 25.9 81.3 9.3 29.6 101.6 29.1 31.2 3.7 24.0 51.5 46.6 1

Argentina 42.0 5.7 20.0 56.3 35.5 40.0 7.0 20.5 53.5 38.3 33.4 2.0 36.9 68.3 54.0 D

Mexio2S" 4.5 -- 240.0 244.5 98.2 2.0 --- 222.0 224.0 99.1 5.0 -- 65.0 70.0 92.9

,/ Demand = Production + Import - Export

i/ Rugh estimate fran fragmentary data

Souroe: Armerican Machinist, McGraw-Hill Inc.

Eoonomic Handbook of Machine Tool Industries, U. S. National Machine Tool Builders' Association

- 149 -

2.35 The growth of the machine tool industry in Mexico was certainly notdemand constrained, as the annual import bill shows. The proximity of thecountry to US sources may have been a factor. In 1975, Mexico was the fourthlargest purchaser of machine tools from the US behind USSR, Canada andBrazil. In fact, the Canadian case would tend to support the geographicalfactor. Until almost 1974, Canada was the largest buyer of US machine tools;only a sudden increase in USSR procurement in 1974 and 1975 pushed Canada tosecond place. However, a more basic reason for the underdevelopment of theMexican machine tool industry in particular and industrial machinery manufac-ture in general has to be found in the national investment priorities andtrade policies. Past investments in the mechanical engineering sector appearto have favored consumer durables, ignoring by and large industrial machineryproduction. Also, major user industries, especially the public sector enter-prises, were able to and did freely import capital goods, including machinetools.

Table 15: U.S. Export of Complete Machine Tools, by Destination

(million U.S. dollars)Valued at U.S. Port

Top Ten CountriesRanked by 1975 Volume 1971 1973 1975

USSR 13.6 30.5 89.1Canada 33.7 57.3 76.7Brazil 13.3 43.6 55.4Mexico 19.2 22.5 40.3U.K. 17.7 19.7 34.8Spain 3.4 10.9 28.2France 14.9 16.4 15.9FR of Germany 14.9 12.2 13.8Venezuela 5.2 7.0 12.4Italy 21.4 12.8 11.6

Total, all countries 267.6 350.5 567.6

Latin American Share in Total (x) 17.4 23.9 22.0

Mexican Share in Total (%) 7.2 6.4 7.1

Source: Economic Handbook of the Machine Tool Industry (1976), U.S.National Machine Tool Builders' Association

2.36 The machine tool industry typically tends to develop along a logicalprogression dictated by the manufacturing as well as technical sophisticationof the using industries, as indicated below, starting with Group I and pro-gressing through Group 2 to Group 3:

- 150 -

Group 1 Group 2 Group 3

Center lathes Turret and Numericallyautomatic lathes controlled

machine tools

Bench and pillar Radial drillingdrilling machines machines

Simple milling Milling machines Special purposemachines production

machines

Small mechanical Grinding machines Transfer machinespresses Boring machines

Sheet metal forming Gear hobbing machinesmachines

Heavy mechanical andhydraulic presses

Several of the more advanced developing countries are now making Group 2machines and have made some progress towards Group 3 machines as well.Mexico has yet to build a solid capability in Group 1 machine tools.

Existing Industry

2.37 The machine tool industry in Mexico comprises four makers of lathes,one maker of hydraulic presses and a dozen or so makers of drilling machines,mechanical presses and sheet metalworking equipment. Total value of produc-tion in 1975 is estimated at below US$5 million. Only limited types ofmachines are made for the low end of the market. The largest buyer is thegovernment purchasing agency CAPFCE which supplies machine tools to schoolsand training centers. Other buyers include in the main small jobbing andrepair shops.

2.38 Potentially, the most significant unit among the lathe manufacturersis Fanamher, a new division of the government-owned AHMSA at San Luis Potosi.It has been in operation since 1975, but has not progressed much beyond theassembly of machines imported from Europe (Yugoslavia, Italy and Spain). Theplant is new and well equipped, but at the time of the mission visit, thefacility was largely idle, presumably because of a slowdown in CAPFCE procure-ment. The product mix covers at least five or six different models of centerlathes, which may not be a problem at the present assembly-only stage, butwould complicate matters of production and parts supply as the local contentis increased. A 5-HP Fanamher center lathe, 200 mm by 1000 mm, sold forabout 150,000 pesos (US$12,000) last year. Its price increased by 40% fol-lowing the first devaluation in September 1976. If there was no further priceincrease, the lathe would now sell for about 210,000 pesos or US$10,500 whichis significantly higher than the price of a comparable center lathe in the US.

Table 16: Profile of Machine Tcol Industry - Mexio

CostType of Main (before devaluation) Capacity

Enterprise Venture Prmduct Market S world nrice Use _____ Dy Renarks

Fanasher Government Center lathe Domestic, 5OX-lOOX Below 50X Assembly of Plant began operation in

(5-7.5 HP) training sdhools above world plant at inmorted nndels 1975: equipped for full

milling machine and repair shops start-up stage nanufacture. but progressmainly has been slow

Famesa Private Center lathe 5QS above 50S Mein sub-asseblies Plant established in 1966

(3-5 HP) world inported

Industrial Private Center lathe lOOS above 50X All major parts made Ctrpany nkiinly nakes punps;

Laqunera (2 HP) world in plant, including machine tool productioncs tings; drive gears started in 1964; plant lacks 'J

inprted neoessary tooling

Macauex 80S Scmex Center lathe Dmestic 80S above At preliminary Assernbly of Calpany is financially

20X private semi-production industry world stage of inported model constrained; need additional

test asserbly financing to equip plant

Hydrarex Private Hydraulic press Domestic Roughly Plant ozrpleted On design and Carpany is only hydraulic

(51S U.S.) 250 ton - 2500 ton industry oaipetitive in 1976 technology press maker in oountry;planrs to aike heavier

presses; also) oould export

- 152 -

2.39 The only production-type lathe made in Mexico is a French Ramomodel under test assembly at Mecamex, a small plant that also produces toolholders and rebuilds old machines. This particular Ramo model, a precision10-HP center lathe, that offers some of the features of a turret lathe, soldin France for about US$10,800 but is no longer in production there. Mecamexhopes to buy the complete tooling from the original manufacturer, but is saidto lack the financial means. This machine would appear to offer excellentmarketing possibilities in Mexico if its price can be brought down to thelevel at which it sold in Europe. At present, all parts for the machine areimported, including the lathe bed casting, and the price ex-factory in Mexicofor a 450 mm by 1500 mm lathe was quoted at 250,000 pesos (US$20,000) beforethe devaluation. This high price could well limit market acceptance.

2.40 Hydromex is the only maker of hydraulic presses in the country.The company has designed and developed its own line of presses and has builta new plant in 1976 to produce machines of 250 to 2500 tons capacity. Mostparts can be produced in-plant, with imports limited to a few critical itemssuch as bearings. The machines are sturdy but unsophisticated, and theirprices appear to be competitive with those in the United States. A 250 tonpress sold ex-factory for about one million pesos before the devaluation; itsprice increased by about 25% following the first devaluation (steel priceincreased by 27%). The product can meet the requirement of the domesticmarket, but should undergo further development before export to the US wouldbe possible.

Development Prospects

2.41 There is no recent census of machine tools in Mexico, and conse-quently the number, type and age of machines in use in the country are notknown. Also, it appears that detailed market forecasts are as yet non-exis-tent; for instance, it is not known how many lathes of the type made in thecountry will be in demand say by 1980.

2.42 Based upon production and import statistics, the demand for machinetools of all types in 1975 is estimated at $245 million. Allowing for thefact that 1974 and 1975 may have been years of unusually high imports, amodest 5% average annual growth of demand has been assumed. Total demand in1980 may then be estimated at about $315 million (at 1975 prices). A reason-able assumption might be that 25% of this demand comprises simpler types ofmachines that could be import substituted. These will comprise machines usedmainly in auxiliary or service activities in the large industries, in smallmanufacturing activities, and in training schools and small repair shops.

Total projected market for simplertypes of machine tools (1980) about $80.0 million

Projected market for general purposetype lathes (1980) about $20.0 million.

2.43 While the above exercise is largely hypothetical, it gives a roughidea of the possible scale to which the industry could grow by 1980. A 25%

- 153 -

import substitution level by then should not be an overly ambitious targetfor Mexico, based upon the experiences of the other developing countries witha comparable industrial sector.

Import Substitution Percentage of Selected Countries

1970 1975

Spain 51.3 47.7Brazil 45.8 59.7India 53.4 74.1Argentina 46.0 64.5

2.44 A possible product mix for the domestic production program couldbe:

Center lathes - 2 modelsTurret lathes - 2 modelsDrilling machines - 2 to 3 modelsincluding radial

Surface grindersTool and cutter grindersMilling machines - horizontal, verticaland knee type

Heavy mechanical and hydraulic presses

It should be advantageous for Mexico to limit the model variety in eachmachine tool category, and to concentrate developmental efforts on thestandardization of parts, so that the problems of parts procurement canbe minimized in the short term. The parts to be standardized may includelubrication pumps, pipes and fittings, valves, spindles, gears, electricalitems as well as special attachments. Also, while the basic machine toolsdesigns must necessarily be imported, attention should be given to thechoice of designs that not only meet the best local user requirements butalso allow easy modifications to satisfy the standardization requirement.

Cost Competitiveness

2.45 Machine tool prices are difficult to compare, since no two machinesfrom different manufacturers are identical. Nevertheless, it can be generallystated that their prices in Mexico are substantially higher than internationalprices. Before the 1976 devaluations, prices of small center lathes wereestimated at 50% to 100% above the prices of "similar" products in the UnitedStates and Western Europe. Devaluation has not changed the situation much,since the import content of these machines is high. The following paragraphsgive some of the reasons for the high cost of Mexican machine tools.

- 154 -

2.46 Material cost: Materials typically account for 35% to 40% of theselling price. In Mexico, the material cost is high because most parts areimported, in small lots. Also, items procured from domestic sources such ascastings and electric motors cost as much as or more than in world markets.There are few reliable suppliers of machine-grade castings in the country, aidbecause of irregular quality, rejection rates of castings are reportedly hig_Since some casting defects cannot be discovered until the final machiningstage, this evidently adds substantially to the material costs of production.Electric motors of requisite quality are locally available, but cost more thanthe landed prices of imports.

2.47 Labor cost: Any wage advantage that Mexico enjoys over the indus-trialized countries is largely offset by low productivity in the plants. Thelow production efficiency is caused mostly by inadequate tooling in the plantsand low capacity utilization; lack of worker training for precision work is anadditional problem in some cases but should be easy to remedy in Mexico.

E. Strategic Considerations for Future DevelopmentHeavy Industrial Machinery and Equipment

2.48 The manufacturing capabilities of the sub-sector are reasonablywell developed, particularly with respect to smaller and simpler types ofequipment. They rely, however, to a large extent on imported technologiesand know-how. Indigenous engineering skills are quite limited and, as mostof the companies in the sub-sector have very little, if any, export business,there is only limited stimulus to improve production efficiencies and toadjust to changes in demand. As a result, domestic manufacturers find itincreasingly difficult to compete with imports, particularly as domesticdemand follows the international trend of calling for increasingly heavierand larger capacity equipment, the manufacture of which requires substantiallyhigher skills and better designs than the industry has been used to.

2.49 Unfavorable cost efficiencies of production and the prevailingdesign and manufacturing skills impose important limitations for taking upand utilizing the current and expected market opportunities of the industry.These contraints - which may require a more detailed diagnosis and catalogof remedial measures than has been possible to indicate in this paper - areexacerbated by the weaknesses of the foundry and machine tool industries inMexico. Because of their importance for the development of the capital goodssector, specific suggestions are made below with a view to delineating anappropriate development strategy as well as supporting policy measures.

Foundries

2.50 The foundry is one of the most important building blocks of themachinery industry, and one in which factor advantages appear to be shiftingfrom the advanced countries to the developing countries. While there havebeen technological advances in this industry worldwide as well as automationof processes where possible, the basic art of casting remains relativelyunchanged and labor-intensive. As a result, countries such as the UnitedStates and Japan have increasingly turned to cheaper overseas sources ofcasting supply.

- 155 -

2.51 Although there are several hundreds of large and small foundries inMexico, the industry is not yet at a stage to adequately support machinerymanufacture or to export. First of all, good foundries are scarce. Next,local casting costs are not internationally competitive. Finally, withrespect to plant machinery and equipment, which are possibly the largestmarket for industrial castings in Mexico outside the automotive sector,there are capacity limitations as to the maximum size and weight of piecesthat can be cast.

2.52 The most important development issue of the foundry industry is notan increase in the total tonnage capacity (which, particularly in low gradecastings, is excessive), but a selective upgrading and expansion of capacitiesthat serve industrial machinery manufacture. Capacity planning should bebased on an analysis of the demand projected to originate in the machinerysector and on the prospects for exports.

2.53 As foundry operations are usually labor-intensive, especially inthe jobbing operations, it is suggested that Mexican labor cost advantages befully exploited with a view of improving the competitive position and exportprospects of the industry.

2.54 Particular attention should be given to an adequate supply of rawmaterials. As scrap of varying quality is virtually the only metal base usedfor iron castings, and a major source of casting defects and other problems,it might be advantageous to consider development of a foundry pig iron supplysource, either as part of an existing steel mill or independently.

Machine Tools

2.55 The fact that the Mexican machine tool industry is virtually unde-veloped within a comparatively large market could be an advantage for thecountry in planning for the future development of this vital industry. Mexicohas a rather unique opportunity to build an entire machine tool industrialstructure literally from scratch.

2.56 Comprehensive planning should be done for this industry, startingwith a machine tool census, to determine the characteristics of the domesticmarket, the opportunities for import substitution and an efficient long-range development strategy. The existing manufacturing programs should becritically reviewed as to measures necessary to direct the industry towardshealthy growth. In particular, the proliferation of models at the low end ofthe market and the problems contributing to high production costs should beresolved.

2.57 The short-term priorities should logically be on the development ofgeneral purpose and semi-production machine tools, some of which are made inthe country already. However, the machine designs and technologies that havebeen imported from abroad should be reviewed as to their appropriateness inthe context of a comprehensive plan, and necessary steps should be takentowards the production of small and medium size general purpose machines of

- 156 -

higher precision with standardized components. While the immediate marketfor these machines will be domestic, they could ultimately be developed forexport to the US where the production of these types of machine tools hasbeen declining because of high labor cost. Several countries have success-fully penetrated this market. Mexico, while in no position to export today,does have a potential competitive edge over other countries by its proximityto the US market and technology.

2.58 Machine tools are precision products that, above all, must giveusers assurance of quality and service. The quality of a center or turretlathe starts with the bed, which is usually cast. This casting must be ofvery high standard, with good dimensional control and definition. The ironin the slideways, for example, must be close grained to wear well. Castingsof this quality can be produced only by specialized foundries. The upgradingof an existing facility or the establishment of a new foundry to serve theprecision machinery manufacturing sector may be necessary.

2.59 Machine tool plants need varied specialized finished parts insmall quantities. Neither reliance on imports nor in-plant manufacture ofthese parts by the end product maker is an economically desirable solutionover the long term. The only way to develop domestic sources of supply ofparts and attachments will be through an industry-wide standardization ofmachine tools by type and size range.

2.60 Machine tools as a group are strategically important to the indus-trialization process and probably best exemplify the level of sophisticatedengineering capability of a country. A ten-fold increase in production valuefrom the current level of about US$5 million by the early 1980's, correspond-ing to a level of import substitution of about 25%, may be an appropriatetarget for Mexico.

- 157 -

III. HEAVY ELECTRICAL EQUIPMENT

A. Profile of the Industry

3.01 The derand for heavy electrical equipment in Mexico closely follows

the dt&velopment program of the Federal Electricity Authority (known as theComision Federal de Electricidad - CFE) which is the sole organization for

the generation, transmission and distribution of electric power. A limitedvolume of electrical equipment in the medium range of sizes is also requiredfor use in large and medium industries and in the diesel-electric and electrictraction systems.

3.02 Heavy electrical equipment may be broadly defined to include thefollowing categories of products:

(i) Generating and Sub-station EquipmentPower generators, high voltage power and instrumenttransformers, circuit breakers, isolators, lightning

arresters and control equipment;

(ii) Transmission Line EquipmentTransmission line towers, insulators, conductors,cables and ancillary equipment;

(iii) Industrial Equipment

Medium voltage transformers, switchgear, AC-DC con-verters, medium and large motors, thyristor speeddrives and control equipment for various industrialapplications.

3.03 The above does not include power distribution equipment, domesticappliances and small apparatus for use in factories, which are outside thescope of the heavy electrical field, being of the nature of light equipmentand durable consumer goods. The demand for these items is almost fullycovered by a large number of manufacturers in Mexico.

3.04 In regard to the three major categories of heavy electrical equip-ment referred to in para. 3.02 above, power generation equipment is almostall imported except for some boilers and auxiliary equipment. There are fourmedium size and one large manufacturers of fairly large capacity power anddistribution transformers, besides 15 small companies which make only distri-bution transformers. The four medium-size companies build power transformersfor I to 15 MVA in voltages up to 110 kv. The one large company (IEM, ajoint venture with Westinghouse) manufacturers medium and large transformersup to 100 MVA for voltages up to 220 kv. Very large transformers above 100MVA - 200 kv and those for service at 400 kv (some of which would also beof ratings highier than 100 MVA) are not yet made in Mexico. One companyBuiatea%, a joint venture with a well known Belgian company) manufacturesinstrunment trazisformers for measurement purposes up to 230 kv. The company

- 158 -

has recently extended its product mix to include 400 kv units, for which CFEhas placed some trial orders. Circuit breakers constitute another importantline of power equipment, and these are required in a wide range of voltagesfrom 0.4 kv (low voltage) to 13 kv (medium voltage) and 33 kv to 400 kv (highand extra high voltage). Two companies produce circuit breakers for low andmedium voltage applications. The whole range of high and extra high voltagecircuit breakers is imported. High voltage isolators and lightning arrestersare also mostly imported.

3.05 In category (ii), transmission line towers for all voltages upto 400 kv are fabricated in Mexico, partly by a private sector company andpartly by a subsidiary of CFE. Conductors of copper and steel-core aluminum,and underground power and telephone cables, except very special types andsizes, are made locally, mostly by four large companies which all have for-eign technical assistance and/or financial participation. Porcelain and glassinsulators for high voltage transmission lines (110-400 kv) are imported asalso the bushings for transformers above 69 kv. The lower range of insulatorsand bushings is produced locally.

3.06 In category (iii), medium voltage transformers for industry andsmall sizes of AC-DC converters are made in Mexico by three companies.Medium size motors (20 HP to 200 HP) are made by seven companies; three ofthem offer motors in the range of 200 to 1,250 HP and one of them up to 2,000HP in the simpler types. Variable speed drives for rolling mills and otherindustrial applications as well as DC motors and generators for diesel-elec-tric and subway systems and for oil drilling rigs, etc. are not produced.Recently, two companies have taken up the manufacture of medium size ACgenerators up to 500 KW for diesel driven generating sets used for stand-bypower supply and other purposes.

3.07 No statistics are readily available to assess the annual demand oflarge and medium electrical equipment covering the three categories discussedabove. An attempt has been made to estimate this data on the basis of pastCFE purchases (new plant and equipment, operation, maintenance, etc.):

- 159 -

Table 17: Selected List of Electrical EquipmentPurchased by CFE During 1973, 1974, 1975

(in million pesos at current prices)

1973 1974 1975Local Import Local Import Local Import

1. Insulators 19 16 40 26 108 912. Alternators &

generators 0 5 0 147 0 1043. Insulating oils 0 24 0 22 15 84. Conductors (copper

& alum.), wires& cables 326 10 644 242 792 90

5. Insulators 1 24 25 28 17 1086. Connectors,

accessories,etc. 18 0 10 3 23 25

7. Circuit breakers 1 54 32 59 13 2258. Unit sub-stations 0 0 0 26 13 79. Transformers 32 38 280 133 560 50810. Transmission towers 115 0 167 0 363 10611. Switch boards 5 5 71 7 60 6812. Turbo-generators 0 384 0 446 0 48813. Watt-hour meters 0 36 67 39 120 4714. Miscellaneous 27 25 17 80 52 82

Total 544 621 1353 1258 2136 1957

In addition to CFE procurement, there are demands for electric motors andgenerators, and other electrical equipment from large and medium industries.The estimated totals are shown in Table 18 which then gives the approximatemagnitude of the heavy electrical equipment demand in Mexico.

- 16o -

Table 18: Demand Trend of Heavy Electrical Equipment in Mexico(in million pesos at current prices)

1973 1974 1975Local Import Local Import Local Import

Total purchased by CFE 544 621 1353 1258 2136 1957

Electric motors* &generators to 10,000HP (estimated) 170 110 200 130 240 150

Electrical equipment(excluding motors &generators) for indus-tries other than CFE(estimated) 77 184 154 183 235 260

Total 791 915 1707 1571 2611 2367

Total of local + import 1706 3278 4978

Percentage of local to total 46.4% 52.1% 52.5%

* CFE uses only a limited extent of motors for large size pumps for

power plants. PEMEX, Irrigation Department and other large industriesand also small and medium industries are the main users of electrical

motors.

Product Range

3.08 For over 40 years the electrical products industry in Mexico cateredmainly to consumer oriented products such as light bulbs, wires, switches,home appliances, etc., and has grown to a level of self-sufficiency in theseproducts. In the last 20 years, small motors and distribution transformerwere taken up and these are now being produced in sufficient quantities tomeet local needs, excepting certain special types. It is only in the lastten years that a number of companies have assumed the manufacture of power

and industrial equipment such as medium and large power transformers, lowerrange circuit breakers, medium size motors, cables, conductors, towers, etc.

3.09 The slow development of the capital goods segment of the electricalmanufacturing industry may be attributed to the following factors:

- the domestic market is limited;

- 161 -

- CFE, PEMEX and other Government organizations, which constituteabout 90% of the demand for power and electrical equipment,often preferred imported equipment because they could importit at concessional or no import duties, at an overvaluedexchange rate which made the foreign exchange cost artificiallylow *n Mexican pesos, and they could finance the imports withspecial credits at low interest rates which were offered byoverseas manufacturers. Moreover, lack of advance planning bythe Government agencies, in part because of their own uncer-tainty as to their budget allocations, also worked to theadvantage of foreign suppliers because they were usuallylarger and therefore could often supply equipment with lesslead time than the Mexican suppliers could;

- the scarcitJ and high cost of domestic capital tended tochannel private investments into production of simplerconsumer type products;

- costs of local products are higher than landed prices ofimported equipment;

- the manufacture of power equipment by companies which areinternational affiliates followed the "assembly" approachto the extent possible, importing components and evensub-assemblies;

- there is very limited local capability or facility fordesign and engineering work; and

- capital goods manufacture requires long learning periodsand intensive traning, and appropriate incentives arelacking.

3.10 In view of the above factors there has been a lack of balanceddevelopment of the industry. In the pattern which has so far emerged, thereare important product lines missing, such as high voltage circuit breakers,high voltage porcelain insulators and bushings, and control gear, which, infact, comprise some of the simpler lines of power equipment manufacture. Toimprove the structure of the industry, attention in planning would have tobe directed equally to the development of domestic supply of these and otherprimary intermediate items as to the expansion of end product lines.

Capacity Utilization

3.11 Most of the companies of the sub-sector worked a full shift. Someof them also ran a second shift with a reduced number of workers. Averagecapacity utilization for the sub-sector may be estimated at around 70% in1975 and less than that in 1976. Production is overly concentrated in anarrow range of products, and there is scope for increased activities if theproduct range and mix would be extended. For example, a number of companiesmake simple squirrel cage motors up to about 40 HP. If they would take upspecial purpose motors (such as wound rotor, DC, etc.) and also extend the

- 162 -

range to say 200 - 500 HP, the work load could increase substantially.Another possibility would be to direct greater attention to exports.

Exports

3.12 The Association of Electrical Equipment MIanufacturers (CANAME) haspublished some data on exports of a number of electrical products. Thereare only eight product groups which come within the purview of this study.These are given in Table 19 below:

Table 19: Export Values for Selected Powerand Electrical Equipment 1973-74

(in million pesos at current prices)

1973 1974 1975

Electric Motors 4.0 10.0 17.6Transmission Towers 11.3 12.9 12.2Transformers 49.9 6.2 19.1Conductors, Wires & Cables 100.0 100.2 143.8Circuit Breakers 20.3 13.1 7.7Contactors 40.4 0.7 29.6Line Apparatus & Accessories 350.6 91.1 130.0 /1

Total 576.5 234.2 360.0

/1 Estimate

3.13 "Conductors, wires and cables" and "Line apparatus and accessories"together account for the bulk of exports, amounting to 78%, 82% and 76% in1973, 1974 and 1975, respectively. These items are all relatively simpleproducts of copper and aluminum with or without insulation. They are usedin the manufacture of electrical machines or directly in the installation ofelectrical equipment and power lines. Total transformer sales in the homemarket amounted to 560 million pesos for CFE in 1975 plus about 40 millionpesos equivalent to industries; and the exports during that year were valuedat 19.1 million pesos only. The corresponding figures for motors were 240million to CFE and 17.6 million pesos worth of export. The main exportmarkets for motors and transformers were Latin American countries, largelyunder the ALALC preferential import duty of 6% against a normal duty of 60%for non-ALALC countries.

B. Problems and Constraints

Raw Materials and Other Supplies

3.14 The basic raw materials and components for this industry are:

- cold rolled grain-oriented silicon sheet steel for transformers;

- cold rolled silicon sheet steel for large size motors and generators;

- 163 -

- copper wires and strips with enamel, glass-fibre, paperor other insulations;

- porcelain bushings and housings for transformers andcircuit breakers;

- castings for small and medium motors; and

- shaft forgings for motors and generators.

Silicon steel sheets are fully imported. While non-silicon sheets areavailable in Mexico, these are used only for small and medium sized motors.Mexico is self-sufficient in copper and in fact exports some quantity assuch; supplies and prices are regulated by the Government. All kinds ofcables, conductors, and wires were produced locally by four large and wellequipped companies. Electrolytic ingot aluminum is mostly imported atruling international prices from the US or Canada. For want of rollingcapacity, until 2 or 3 years ago, aluminum was imported in wire form. Sincethen, the four major producers of cables and conductors have put up a jointcompany for aluminum rolling to meet their own wire needs. Porcelain com-ponents for voltages above 69 kv are not yet made in Mexico and are imported.While castings for electric motors are locally supplied, shaft forgings oflarge diameter for motors above 500 HP are imported.

3.15 The main problem in regard to raw materials and other suppliesappears to be the procedural delays in obtaining approval for imports. Inthe past, 25% of the value of each imported category could be availed ofwithout a formal license and this was apparently helpful in executing urgentorders and avoiding intermittent production runs. However, this privilegeis no longer available, and some suitable system to overcome the consequentdifficulties appears to be needed.

3.16 In domestic supplies there is very little sub-contracting to localancillary industries. The end product makers, by and large, make even rela-tively simple fabricated and machined parts in-plant, despite the obviousdiseconomies of such operations. The problems of expansion and upgrading ofthe local ancillary industries merit attention. -

Technology

3.17 Many of the local manufacturers are subsidiaries or joint venturesof well known international electrical equipment manufacturers. The latterparticipate in the management of the firms and also supply their technolog-ical needs (design, engineering, and manufacturing techniques). In viewof the easy access to engineering information and drawings from the parentcompanies, there has not been any impulse in Mexico to take on furtherdevelopment work leading to new designs of local origin.

3.18 There are also no significant efforts within the plants or byoutside institutions directed towards import substitution of raw materialsand components, nor are there adaptations and innovations aimed at costreduction or better performance of equipment under local conditions.

- 164 -

3.19 In regard to the choice of technology, while modern and up-to-dateproducts should be selected, the techniques of manufacture need not adoptthe highly mechanized processed used in the industrially advanced countriesto save labor. For example, medium and large electric motors of the mostmodern designs could still use hand prepared and wrapped insulation andmanually wound coils. The winding, assembly, shop movement and testingcould be done with maximum use of labor. 1/ Almost in every product linethere are some possibilities for manually worked processes and operationsand these should be identified. That way projects could be made less cap-ital intensive and more employment oriented. In heavy electrical equipment,there is, however, little latitude for design variation as it will have toconform to clear-cut test specifications of international standards. Never-theless, a system of technology clearance could be used, with representationfrom all interested parties such as the equipment manufacturers, CFE andthe government, to ensure that design or engineering modifications areappropriate to the need of the country and will be acceptable to the users.

3.20 In addition to Mexico's own equipment needs, the prospects forexports to Latin American countries should be kept in mind in the selectionof technology, as some of them, e.g., Argentina, Chile and Bolivia, followthe European standards of 50 cycles frequency and of 220 V for domestic use.A few countries, such as Brazil, have both 50 and 60 cycle systems in service.

Product Quality

3.21 CFE and other user industries seem to have no major complaints asto the quality of domestic products, except that certain proving tests onmajor equipment (large transformers and motors) are not performed for wantof adequate testing facilities. In such cases, the manufacturers usuallyseek exemption on the strength of their foreign collaborator's design tests.While such exemptions are often given, the situation should be remedied,as it is necessary that manufacturers should be equipped to conduct a fullrange of tests on equipment actually made in Mexico, rather than continue torely on tests conducted abroad on original designs. This may well become acrucial point in regard to exports, as foreign buyers can be expected toinsist on actual tests and inspection in conformity with their own nationalor international codes.

3.22 CONACYT is promoting the formulation of Mexican national standards,and several committees composed of manufacturers and users have been set up;but progress has been very slow.

Skill of Workers

3.23 There seems to be a general concensus that the Mexican worker ac-quires new skills with relative ease. However, in the electrical equipment

1/ In one medium size electric motor plant in Mexico, the entire statorbody and rotors are made in die-cast aluminum by the use of a veryexpensive automated die-casting plant.

- 165 -

industry, it would appear that adequate attention is not yet paid to intensivetraining programs, and the percentage of skilled workers to semi-skilled andunskilled workers is strikingly low, at around 20%, in comparison with levelsof around 40% in some other comparable countries. The practice of hiringworkers in the l^west wage brackets would reflect adversely on productionefficiency. Mobc companies do not have worker incentive schemes. A notableexception is the affiliate of the West German Siemens, which produces smalland medium range motors up to 250 HP with a total work force of about 300people. By means of a three year apprentice training program and an incen-tive scheme, a labor productivity of 90 to 100% of German norms is claimedto have been achieved, making this factory one of the front line overseasplants of the group.

Finance

3.24 As in other sub-sectors of capital goods industry, shortage ofworking capital is a major problem of this sub-sector, and there is theadded problem that CFE and Pemex have in the past often delayed paymentof bills by several months. In regard to capital funds for expansion andimprovement projects, some of the arrangements already made with local andforeign banks seem to have suffered a setback as a result of the 1976 deval-uations. Also, some companies which were making plans for expansion on thestrength of their peso reserves, now find these inadequate on account of thelarge increase in project costs following devaluation.

3.25 Further problems arise from Mexican restrictions on foreigninvestment. For example, General Electric had put forth two new projects,one for large motors and generators and the other for polyphase motors. Inboth instances the foreign equity financing, as proposed by G.E. (US) wouldhave been substantially higher than the 49% limit on foreign investment.International companies appear to be averse to accepting the 49% ceiling,for fear of losing management control to Mexican partners or to governmentfinancial institutions, notably NAFINSA.

C. Production Costs

3.26 Prices of industrial products made in Mexico are reportedly 20 -40% above the landed price of comparable imports. One reason is the highercost of raw materials and intermediate components. Even copper wire man-ufactured from domestic copper is priced higher than in internationalmarkets. Other key materials such as silicon sheet steel and porcelainbushings are available to manufacturers at international prices throughimports. The remaining items such as steel plates and sheets, insulatingmaterials, and castings together may account for about 30% by value ofthe material content of electrical equipment. Additional reasons for thehigher material costs of production are believed to lie in the highermaterial content of the Mexican products (older designs) and in higherrejection rates during manufacture.

3.27 There is a general impression that labor costs are low in Mexico,like in many other developing countries, but to a large extent this is not

- 166 -

true. The monthly wage for a skilled worker in an electrical factory in thesuburbs of Mexi^^ City is around 5,000 pesos (post devaluation), plus socia.benefits amounting to 60%, making a total of 8,000 pesos, or about US$400.Labor efficiency, as indicated by some plant managers, is said to be about60% of that of US electrical workers, and if an allowance is made for this,the apparent cost of Mexican labor that would compare with one US worker maybe estimated at about $670 per month. If the wage plus social benefits of aUS worker are $1200 per month, the differential between the two narrows downto a ratio of 1:1.8. However, in spite of this wage advantage, Mexicanfactories may not compare favorably with US plants due to the automation,mechanical handling, better shop loading, superior maintenance, and materialflows organization at the latter.

Table 20: Profile of Representative Electrical Equipment Makers in Mexico

Domestic Capacity

Type of Number of Market Utilization

Jompany Venture Main Product Line Employees Share (1975) Remarks(x) (X)

Industria Electrica Mexico 56% Transformers to 100 MVA 1800 30 70 Recently

de Mexico (IEM) Westinghouse 26% Motors to 200 HP, (average) started some

Others 18% Circuit breakers to 69 KV export.

plus home appliances

C.E. de Mexico us Transformers to 7500 KVA, 4500 n.a. 90 Negligible

motors to 200 HP and (30% in export

Circuit breakers to 66 KV, industrial

plus consumer products products) a

Reliance de Mexico 100% Mexican tIotors, alternators and 350 n.a. 60 Ownership

control equipment transferredfrom RelianceMotors of USto Mexico in1975, negli-gible export

Condumex 52% Mexican Wire and Cables 1700 40 70-90 5-10% of output

48Z Foreign ~~~~~~~~~~~~~~exported, but48Z Foreign

prospects limited

(Anaconda of US because low labor

and Pirelli of content and small

Italy) production scale

- 168 -

D. Development Prospects

3.28 CFE is the sole market for large power generation machinery andthe high voltage transmission line and sub-station equipment. Accordingly,the product mix and the pattern of growth for the heavy electrical manufac-turing industry is determined by the long-term plans of CFE for the nationalpower supply system. The CFE has made estimates of the long-term powerrequirements of the country and the growth of installed capacity through1990. 1/ The anticipated expansion, of power generating capacity is shownin Table 21 below.

Table 21: Projected Growth of Power Generating Capacity (MW)

Installed Projected1974 % 1980 % 1990 X

Hydro-electric 3,387 42.8 5,170 31.8 12,480 31.2

Thermal (oil fired)including diesel & gas 4,420 55.9 9,650 59.3 13,460 33.6

Thermal (coal fired) 30 0.4 630 3.8 5,430 13.6

Geothermal 75 0.9 180 1.1 490 1.2

Nuclear 0 0 650 4.0 8,160 20.4

Total 7,912 100.0 16,280 100.0 40,020 100.0

3.29 The total installed capacity increased from 7900 MW in December1974, to about 11800 MW in December 1976. The ongoing construction programis reported to be making good progress towards the achievement of the 1980targets. So far, the country's resources for power generation have beenlimited to water power and fuel oil, but their combined share is projectedto decline to about 90% in 1980, and 65% in 1990. The share of coal-firedplants and nuclear plants, on the other hand, is projected to increase fromless than 1% today to 34% of the total generating capacity by 1990. Inrecent years, large deposits of non-coking coal at Rio Escondido and otherareas have been discovered and are being developed energetically.

1/ Ing. Jacinto Viqueira Landa (CFE):Necesidades Futuras de Maquinaria para la Generacion de Energia Elec-trica, August 1975; andDemanda Futura de Bienes de Capital para la Produccion y Transmisionde Energia Electrica, December 1975

- 169 -

3.30 The CFE projections assume:

- adequate coal reserves and supplies would be establishedfor a total installed capacity of over 5000 MW of coal-fired t>ermal power stations;

- the development of about 12,500 MW of hydro-electricgenerating capacity, equivalent to about 50% of thecountry's available hydro-electric potential;

- some potential for the development of geothermal re-sources in Mexico.

In regard to thermal plants burning fuel oil and to nuclear plants, noresource limitations are assumed to exist in view of the present self-sufficiency of Mexico in petroleum and the availability of uranium ininternational markets. Nevertheless, the oil-fired thermal plants havebeen de-emphasized on the grounds of their relative generation economies.Table 22 gives a detailed list of the plants scheduled to come on streambetween the years 1980 and 1990.

3.31 The total investment required for the new generation capacity of24,000 MW, that is to be added during 1980-1990 has been estimated at about120,000 million pesos (at 1975 prices). This amount excludes outlays on newtransmission and distribution facilities. If all the major power plant andequipment would have to be imported in future as at present, about 50% ofthe total investment would be the cost of imports based on the followingbreak-down. The local expenditure would comprise the cost of civil andstructural works as well as that of simple types of ancillary equipment.

Local. (%) Imports (%)

Nuclear Plants 35 65Thermal (oil) plants 55 45Thermal (coal) plants 60 40Hydro-electric plants 60 40

3.32 The financial resources of CFE are anticipated to be a major con-straint to achieving the planned expansion of the power generating capacity,particularly in view of the heavy foreign exchange requirements involved.This suggests that Mexico should seriously explore the feasibility of localmanufacture of power plant equipment ranging from heavy mechanical (boilers,turbines, etc.) to heavy electrical equipment.

3.33 In the projected expansion program, the nuclear capacity of 7508MW includes 1308 MW of the Laguna Verde Project, which is already underconstruction but expected to be commissioned only in 1980-82. The programfurther calls for nuclear plant additions of 600 MW each in 1984 and 1985,followed by 1000 MW every year from 1986 onward. In the nuclear powerplants, opportunity for local equipment supplies should be expected to berather limited.

- 170 -

Table 22 CiIFE Conatruation Propam of Now Power Plante (1980-90)

THERNAL (OIL) THRUL (COAL) HYMRO-ELCTRIC NUZLZAR GAS TURBN:MBER NNNBER NUZR -

ZtAR & ZE rOTAL & 5ZE TOTAL & SIZE TOTAL & SIZE TOTAL & SIZE TOTAL TOBAL _

(Mf) (w) NO (4') }) )

1980 1x 150 1 x 302x300 750 4 x 300 1200 1 x 55 85 2035

1l61 1x37 37 3 x 300 900 1x300 300 1 x 654 65 4 1 x 55 55 19)46

1982 2x 371x150 224 1 x 300 300 2x 77 154 1 x 65 4 6r4 1 x 55 55 1387

1983 lx202x 37 2x4l21x150 4x 453x300 1124 3x29 l 54Ix 1 x55 55 2033

1984 1x 202 x 300 600 4 x l0 420 1 x 600 600 1620

1985 2 x 841 x l%0 318 1 x 300 300 3x 180 540 1 x 600 6'xo 1758

1986 1x 84 1x 1351 x150 234 1 x 300 300 2x L.50 45 1 x lXO 13)0 1 x 30 30 1999

1987 2 x 1303 x 135

2x x84 168 2 x 300. 600 2x .50 965 1 x 1000 1030 27S3

1988 2x 802 x 137

2x x84 168 2 x 600 1200 1x L50 584 1 x 1000 1C00 I x 30 30 2982

1969 2 x 502 x 103 x 150

2x 84 2 x175L x15o 318 2x180 146o 1 x 1Wo 12)00

1990 2x 84 2x1252x150 468 1 x 600 600 1x150 400 1 1CX l Lo I.

2 @ 208 042 to 32

59 37 41 @77 to 8011u 84 16S 100 to 137 2 o .8 3150 10 @ 300 19@150 to 190 2 :5@300 3 9@600 o@300 5 @ 1000

29 3809 13 4800 54 7312 9 7f508 7 310 23,739

- 171 -

3.34 The planned hydro-electric installations amount to 7312 MW. Theyinclude five units of 300 MW each for commissioning in 1981-82 and 49 smallerunits ranging in size from 20 MW to 300 MW. This could provide adequatework load for a manufacturing plant with an output of 5 to 6 turbo-generatorsets annually.

3.35 In regard to the demand for steam turbo-generator sets for coaland oil fired stations, the demand over the 10-year period would be asfollows:

3 of 600 MW (for coal)15 of 300 MW (5 for oil and 10 for coal)8 of 150 MW (for oil)11 of 84 MW (for oil)5 of 37 MW (for oil)

Thus, the total requirements would comprise 42 sets for a combined capacityof 8609 MW.

3.36 It appears that the projected demand for heavy mechanical andelectrical equipment for the CFE program alone could justify a major newmanufacturing unit to produce turbines and matching generators for thehydroelectric and thermal (coal and oil) power installations. This couldperhaps expand to provide nuclear power plant components at a later date.In addition, there will be demand for heavy auxiliary equipment requiringspecialized fabrication. These items could be made in the large mechanicalworkshops of the public and private sector.

Power Transformers

3.37 The total demand for medium and large power transformers, exclud-ing distribution transformers, was about 6000 MVA in 1976. It could growto about 10,000 MVA by the mid-1980's (UNIDO-NAFINSA study). The existingproduction capacity in Mexico is around 3000 MVA, with some expansionschemes in progress. Major constraints of the manufacturing firms have beencost competitiveness and financial resources. Considering the anticipatedlong-term growth of transformer demand, Mexico should promote a more rapidexpansion of the present production capacity through appropriate incentives.There may even be scope for establishing a new modern transformer facilitycapable of producing large size transformers (200-400 kv) that are nowimported; but the cost-benefit implications of such an import substitutioneffort will have to be carefully assessed first.

High Voltage Circuit Breakers

3.38 Above 69 kv, all circuit breakers are imported. The value ofimports in 1975 was 225 million pesos, a sizeable jump from the 50 to 60million pesos in 1973 and 1974. The demand, which is wholly from CFE, couldjustify the local manufacture of breakers in the voltage range of 115, 230

- 172 -

and 400 kv. It is understood that Siemens of West Germany has submitted toNAFINSA a proposal to manufacture high voltage circuit breakers, and theproposal would merit detailed appraisal.

High Voltage Insulators and Bushings

3.39 This is an essential industry for CFE's transmission lines. Also,transformer and switchgear manufacturers require bushings up to 400 kv. Theswitchgear manufacturers will additionally need porcelain arc chambers andsupports for voltages up to 400 kv. It is learnt that one of the two exist-ing porcelain manufacturers has proposed to cover the whole range and isnegotiating with prospective foreign collaborators.

Motors and Generators Up to 10,000 HP

3.40 The present demand for sizes up to 200 HP is being met by localproducers to about the full extent. The range from 200 - 10,000 HP in alltypes is only covered partially in sizes up to 1250 HP for motors and 500 KWfor AC generators. Important product lines are special DC motors and AC gen-erators (including converters) which are required for diesel-electric loco-motives and oil drilling rigs now under production in Mexico, with importedelectric motors/generators. In all, the demand is estimated at around onemillion HP of which about 40% could be met by expanded local production.Three or four manufacturers are expanding their range and volume of pro-duction; moreover, NAFINSA is said to have under consideration a GE (US)proposal to cover the full range of Mexico's long-term demand.

Miscellaneous Equipment

3.41 In addition to the above main items, there are a number of auxiliaryitems for which domestic demand could probably be developed profitably.These are high voltage lightning arresters and fuses, polyphase watt meters,industrial and traction control equipment, meters, relays, etc.

3.42 CANAME has made an assessment of the new and expansion projectsplanned for the six-year period from 1977 to 1982. Details are shown inTable 23. Excluding the facilities for power generators and four otheritems, which are stated to be "under study", the total capital investmentinvolved was estimated at 982 million pesos (pre-devaluation). Total prod-uct demand in the six-year period was estimated at 11,936 million pesos(pre-devaluation), and the corresponding value of production would constituteimport substitution (not deducting the value of imported inputs) at 8,263million pesos. Exports worth 371 million pesos were also envisaged. Theseprojections are a useful starting point for the detailed consideration ofprojects for expansion of existing facilities and establishment of new ones.

- 173 -

Table 23: MAJOR INVESITMUT PROJECTS IN ELECTSICALXkAlITFCTR, As cWTWE BY CANAME

(Data for 6 years, 1977-82)(All figures in millions of pesos - predevaluation)

P_oduction Required InvestmentEstimate Of Import Probable Total ital Wk ng Jobs CreatEd

Domestic Demand Substitution %worts Volume Investment Capital (Numbers)

DC Motors & Generatorsup to 12,000 HP 1,845 1,187 143 1,230 195 90 350

Traction 450 350 - 350Others 1,395 837 43 880

Large AC Motors up to12,000 HP (range not coveredso far) 835 405 35 440 90 55 145

Generators up to 1500 KW 790 595 28 623 125 75 205

Traction Equipment for Locomotives 15 365 - 365 55 40 lorc

Power Generators Under Study

High Voltage Circuit Breakers 1,350 954 75 1,029 80 170 250

High Voltage PorcelainInsulators 1,160 750 - 790 110 70 180

High Voltage Isolators 1,220 790 - 790 60 85 210Lightning Arresters 140 90 10 100 12 20 50High Voltage Fuses 180 120 - 120 15 20 60

Voltage Regulators forDiatribution 225 200 50 250 15 15 90

High Voltage, Nlgh Power Transformer80 1,195 II(' 110 1,5n5 1tSO 7m e'

Polyphase Watt Meters 276 207 20 227 20 65Phase Isolated Bas-Bars Under StudyControl System and Equipment forIndustry, Traction, etc. 2,050 1,205 - 1,205 45 140 250Electric Relays Under StudcyMeasuring Instruments & Iquipment Under StudyMeasuring Transformers -Under Study

Totals 11 Mr6 26- 371f 867i in

NOTES:1. Value of estimated investments is based on an assumption that, in several cases, the present

installations could be partially used for implementation of new projects.2. Values in the column "Import Substitution" refer to the finished product being substituted.

Because some inputs will contimue to be imported, the net value of substitution is smaller.

- 174 -

E. Strategic Considerations for Future Develo2ment

3.43 In the electrical equipment sub-sector, the manufacturing emphasishas been on consumer products in the past. Of industrial products, only someof the simpler items are made, principally in transmission line and substationequipment. The heavy items are almost all imported. Wlhere there has beensome local production, the tendency has been to assemble rather than produce.As the list of projects compiled by CANAME suggests, there are opportunitiesto significantly expand the national production of heavy electrical equipmentand to broaden the range of output. But a basic problem appears to be thatdetailed studies have not yet been done to determine the relative prioritiesamong the projects and develop the strategy to be followed to make use ofMexico's comparative advantages.

3.44 The supplier sector should be given particular attention. At atime when the price of billet copper was US$1420 per metric ton (October1976), the price of bare rectangular copper strips (drawn and shaved to size)was stated to be US$2500 per ton in Mexico as against US$2000 in the interna-tional market. The price disparity was even greater in respect to enamelledwire, the export price of which was US$2440 per ton against the local priceof US$4620 per ton. The insulating materials and chemicals supplied by PEMEXand the other local firms are also priced too high in comparison with imports.Measures should be taken to bring the prices ofWrimary and intermediateinputs more in line with international prices.

3.45 Price competitiveness should be a maj: ^lopment criterion.Transformers of all sizes and medium to large motors -il for a large amountof manual work (skilled and semi-skilled) and have some cost advantagesfor manufacture in Mexico. Measures to improve production efficiency meritpriority attention, including better in-plant training of workers and super-visors.

3.46 Improved medium and long-term planning throughout the economy, andespecially in the CFE (which is the largest consumer of heavy electricalequipment in Mexico) would facilitate the ability of Mexican producers ofcapital goods to meet local demands. This improved planning, to be effec-tive, would have to include not only project planning, but also overallfinancial planning of public sector investment programs, so CFE and otherpurchasers of equipment could be assured of future financial flows andthus be able to plan their purchases in a reliable manner. The Mexicanadministrative reforms of January 1977 should prove to be helpful inmeeting this need, as they provide a useful framework for specific improve-ments on the level of enterprises.

3.47 For the near term, the demand for Mexican heavy electrical equip-ment will largely be limited to the domestic market. While some export toLatin American countries may be possible, particularly under the ALALC andother bilateral agreements, it is a characteristic of the heavy equipmenttrade that a number of units must be placed in service and a satisfactory andtrouble-free performance record be build up over several years by a producingtinit before customers abroad will have the confidence to place orders formajor equipment with it.

The World Bank

Headquarters European Office Tokyo Office1818 H Street, N.W. 66, avenue d'Iena Kokusai BuildingWashington, D.C. 20433, U.S.A. 75116 Paris, France 1-1 Marunouchi 3-chomeTelephone (202) 477-1234 Chiyoda-ku, Tokyo 100, JapanCable Address INTlBAFRAD

WASIIINGTOND(C