Documentof The World Bank FOR OFFICIAL,USEONLY ReportNo. 34552-MX INTERNATIONALBANK FORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT ONA PROPOSEDFIRSTPROGRAMMATIC FINANCE AND GROWTH DEVELOPMENTPOLICY LOAN INTHEAMOUNT OFUS$501.26MILLION TO THE UNITED MEXICANSTATES January 27,2006 Finance, PrivateSector andInfrastructureDepartment ColombiaandMexicoCountryManagementUnit LatinAmerica andCaribbeanRegion This document has arestricteddistribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosedwithout World Bank authorization. UNITEDMEXICANSTATES - GOVERNMENTFISCALYEAR January 1-December 31 CURRENCYEQUIVALENTS (Exchange Rate Effective as of January 26 2006) Currency Unit Peso 10.50Pesos = US$1 Weights andMeasures Metric System SELECTEDABBREVIATIONS AND ACRONYMS Afore Administradora de Fondos para el Retiro (Pension Funds Administrator) BdM Banco de Mexico (Central Bank) CPS Country Partnership Strategy CNBV Comisih Nacional Bancaria y de Valores (National Banking and Securities Commission) CNSF Comisi6n Nacional de Seguros y Fianzas (National Insurance Commission) CONSAR Comisi6n Nacional de Sistema de Ahorro para el Retiro (National Pension Savings Commission) DB Government-owneddevelopment bank DPL Development Policy L o a f i n d i n g FM Financial Management FOVISSSTE National Housing Fundfor Public Sector Workers GDP Gross Domestic Product GoM Government of Mexico INFONAVIT National Housing Fundfor Private Sector Workers IPAE3 Instituto para la Proteccih del Ahorro Bancario (Banking Savings Protection Institute, the Mexican deposit insurance corporation) MBS MortgageBacked Securities MexDer Mexican Derivatives Exchange MI MortgageDefault Insurance PRONAFIDE Programa Nacional de Financiamiento de Desarrollo (National Program for Financing Development) PSBR Public Sector Borrowing Requirement ROSC Report on the Observance of Standards and Codes SHCP Secretana de Hacienda y Crkdito P6blico (Ministry of Finance) SHF Sociedad HipotecariaFederal (Federal MortgageInstitution) Siefores Sociedadesde Inversi6n Especializadas en Fondos para el Retiro (Retirement Savings Institutions) Sofoles SociedadesFinancieras de Objeto Limitado (Financial Institutionswith Limited Purpose) Vice President: Pamela Cox Country Director: Isabel Guerrero Sector Director: Makhtar Diop Sector Manager: Susan Goldmark Lead Economist: David Rosenblatt Sector Leader: Anna Wellenstein Task Team Leader: Juan Carlos Mendoza LOANAND PROGRAMSUMMARY UNITEDMEXICANSTATES FIRSTPROGRAMMATICFINANCEAND GROWTHDEVELOPMENTPOLICY LOAN Borrower United Mexican States ImplementingAgency Secretariade Hacienday Crkdito Pliblico (SHCP, Ministry of Finance) Amount US$501.26 million Terms Commitment-linkedfixed-spread loan in US dollars. Total repayment term of 15-years,including a 5-year grace period. Tranching Single tranche operation Description This proposed operation would support policy reforms in three areas: (i) strengthening market integrity and prudential regulation to set the foundation for continued sustainable growth of the financial sector; (ii) increasing the depth, access and diversification of financing to foster a more effective role of the financial sector in the development of the economy; and (iii) promoting diversified investment instruments to complement the aim of increased financial access through enhanced national savings levels and investment vehicles. Benefits The proposed loan would support sustainable growth and poverty alleviation by: (i) contributing to reduce the probability of a systemic financial crisis; (ii)fostering the sustainable growth of a financial system and capital markets that address the needs of the productive sector and increase the overall competitiveness of the economy; and (iii) increasing the diversification of savings and investment instruments available to households and institutional investors. Risks The main risks faced by the proposed operation are associated with the political transition that will take place as result of the presidential elections scheduled for July 2006 and the potential for macro-economic instability during the electoral period. The reforms that would be supported by the two operations of this program are, however, related to aspects of the financial sector agenda on which there is broad consensus among key political actors and which the Government i s already actively implementing. Therefore, this limits the risk that the actions already taken could be reversed and that the indicative triggers of the next operation may not be reached within the 18 months following the effectiveness of this first loan. Additionally, an important part of the reforms supported by this loan are targeted at reducing the impact on the financial system of any potential macro-economic instability that could be generated by political volatility. Operation ID Number PO97159 FOROFFICIAL USE ONLY This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. UNITED MEXICAN STATES FIRSTPROGRAMMATICFINANCEAND GROWTHDEVELOPMENTPOLICY LOAN TABLEOF CONTENTS LOANAND PROGRAMSUMMARY 1 I. INTRODUCTION ............................................................................................................................. .......................................................................................................... 2 11. COUNTRY CONTEXT .................................................................................................................... 3 RECENTECONOMICDEVELOPMENTSINMEXICO 111. THE OVERALL GOVERNMENT PROGRAM ......................... IV. KEY ISSUESINTHE FINANCIAL SECTOR .............................................................................. 7 V. BANK SUPPORT TO THE GOVERNMENT'S STRATEGY ..................................................... 29 LINKTO CPS ... ........................................... .29 RELATIONSHIP TO OTHER BANK OPERATIONS. LESSONS LEARNED................................................................................... VI. THE PROPOSEDFINANCE AND GROWTH DPL .................................................................... 34 OPERATIONDESCRIPTION ...................................... 34 POLICY REFORMS SUPPOR C SERIES....... LOANAMOUNT ................................................... .............. VII. OPERATION IMPLEMENTATION .............................................................................................. 48 POVERTY AND SOCIAL IMPACTS................................................................................. 48 PUBLIC PARTICIPATION.. .......................................................... 50 IMPLEMENTATION, MONITORING AND EVALUATION FIDUCIARYASPECTS, DISBURSEMENTAND AUDITING ...... ENVIRONMENTALASPECTS............................................................................... RISKS AND RISK MITIGATION....................................................................................... 53 ANNEXES ANNEX 1:LETTER OF DEVELOPMENT POLICY .............................................................................................. ................................................................................. 55 ANNEX 2: OPERATION POLICY MATRIX 78 ANNEX 3: FUNDRELATIONS NOTE ........................................................................................................ 81 ANNEX 4: COUNTRY AT A GLANCE. ...................................................................................................... 85 ANNEX 5: MEXICO- OPERATIONSPORTFOLIO(IBRD/IDA) AND GRANTS ............................... 87 ANNEX 6: STATEMENT OF IFC'S HELD AND DISBURSEDPORTFOLIO ......................................................................................................... ....................................... 88 ANNEX 7: ANALYTICAL SOURCES 89 MAP IBRD33447 The World Bank Group greatly appreciatesthe close collaborationof the Government of Mexico inthe preparationof this Development Policy Loan. This operation has been prepared by a team composed o f Juan Carlos Mendoza (Task Manager); Hela Cheikhrouhou, Martin Naranjo Landerer, Constantinos Stephanou (LCSFF); William Britt Gwinner (OPD); Joost Draizma, David Gould, (LCSPE) Mary Morrison (LCSFP); Emanuel Salinas Muiioz (YPP); Juan Carlos Alvarez (LEGLA), Victor Ordoiiez (LCOAA), Solange Berstein, Mariluz Cortes and Alexia Santallusia-Serlavos (Consultants). The team benefitedfrom the comments from other Bank staff including: Miguel L6pez-Bakovic(LLClC), Todd Crawford(LCOQE) and peer reviewers: Marilou Uy, PatrickHonohan, Roberto Rocha (OPD) and Aquiles Almansi (LCSFF). Editorial assistancewas providedby HelenaIssa. INTERNATIONALBANKFOR RECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENTFOR A PROPOSEDFINANCEAND GROWTHDEVELOPMENTPOLICY LOAN TO THE UNITED MEXICANSTATES I. INTRODUCTION 1. The Government of Mexico (GoM) has taken great strides in consolidatingthe stability of the financial sector. In the banking system, legal and regulatory reforms have fostered a more solidly capitalized sector operating under a prudential framework consistent with best international practices. Important reforms to the public banking sector have narrowed its focus thus limiting the potential for economic distortions as well as the creation of contingent liabilities for the GoM from its lending activities. Mexico has been a regional leader in the promotion of non-bank financial institutions, while avoiding their use for regulatory arbitrage purposes. In particular, their role has been essential in reinvigorating the housing finance sector, an area where Mexico i s developing an increasingly sophisticated financing system. Enhanced corporate governance framework, supervision and institutional arrangements have also fostered the development of the capital markets. The most recent reforms have focused on the development of the equity markets, which have been lagging behind fixed income markets, a pervasive issue among emerging economies. Similarly, Mexico is addressing some of the most serious limitations being faced by countries that have reformed their pension plans towards privately-managed accounts. These limitations include limited competition among private pension administrators and the misalignment between workers' and administrators' incentives. 2. An ongoing program of reforms seeks to foster sustainable growth of the financial sector. The GoM has more recently embarked on a series of policy and institutional reforms which not only seek to continue strengthening financial sector stability, but also seek to promote the growth of a more diversified financial sector, offering a broader range of competitive financing and savings mechanisms to contribute more directly to the country's overall economic growth. The Bank's support for the GoM's program of reform would consist of a two-phased programmatic development policy lending (DPL) operation. The entire program would be carried out over a period of 18 months and would be complemented by analytical work done at the request of the GoM on specific policy areas covered by the program. The first operation - the US$501.26 million proposed here - would support these aims through reforms in three policy areas: (i) strengthening market integrity and prudential regulation to set the foundation for continued sustainable growth of the financial sector; (ii) increasing the depth, access and diversification of financing to foster a more effective role of the financial sector in the development of the economy; and (iii)promoting diversified investment instruments to complement the aim of increased financial access through enhanced national savings levels and investment vehicles. Key triggers for the preparation of the second operation reflect continued reforms in these areas, including (i)the creation of a transparent banking resolution mechanism; (ii) strengthening the infrastructure for housing finance; and (iii) enhancing investment strategies and competition in the pensions industry. The second operation would be prepared provided that the reforms supported by this first proposed loan are sustained and that macroeconomic stability inMexico continues. 3. The GoM has chosen to move ahead at this stage on those areas of the financial sector policy agenda on which broad political consensus exists. This approach seeks to minimize the risks associated with a program of reforms that that will be implemented during an electoral period and will span two presidential administrations. 2 11. COUNTRY CONTEXT 4. A combination of fiscal discipline, prudentmonetary policy and a positiveinternational environment (particularly an improved U.S. economy) has fostered uninterrupted economic growth since mid-2003. The institutional strengthening of Mexican economic policy-making over the last decade has been reflected in the avoidance of instability during the last presidential transition, in 2000, and in the avoidance of a crisis during the most recent slow-down of the U.S. economy inthe 2001-2002 period. The ensuing recovery has been broad-based. Business confidence and investment have risen, foreign direct investment inflows have strengthened, exports have pickedup sharply, and market perceptions of Mexico remain favorable. 5. Financial sector stability indicators have continued to improve, not only due to improved macroeconomic indicators but also due to continued upgrading of the legal and regulatory framework. Since the 1994-1995 financial crisis, the last two administrations have concentrated their efforts in the financial system on improving the legal and regulatory framework, strengthening supervision, and fostering the entrance of foreign financial institutions to provide a bulwark against potential instabilities in the system generatedby macroeconomic shocks. As a result of these initiatives, the main component of the financial sector, the banlung system, has cleaned up its balance sheet and improved its prudential indicators to international standards. 6. Mexico's consistent macroeconomicmanagement during the last decade has generated confidence in international financial markets that instability will be limited during the upcoming electoral period. The period that led to the election of the current Administration broke the cycle of financial instability that had been associated with previous presidential transitions in Mexico. International markets reflect at this stage continued confidence in Mexico, as shown by the recent evolution of Mexican sovereign debt spreads (Figure 1). In addition, as in 2000, Mexican policymakers are in a position to take additional measures to reduce economic and market vulnerabilities in case of adverse developments or prolonged political uncertainty. Already, the GoM has announced the pre-funding and prepayment of external public debt service obligations due in 2006 and 2007, thereby suggesting it will not need to return to international bond markets throughout this period. Figure 1:EmergingMarketsRiskPremium 600 -~~ " I I ~ ~ , ~ I JanU4 Mar-04 Map04 JUI-M Sep04 NOY-04 Jan-05 MaiQS May-05 JuIOS SepOS NOY-05 Time Source: JP MorganEmergingMarkets Bond Index (EMBD 3 RECENTECONOMICDEVELOPMENTSINMEXICO 7. Since mid-2003 the Mexican economy has gained momentum by taking advantage of the global economic recovery and high international oil prices, though growth is slowing. After a strong rebound of economic activity in 2004-when GDP rose 4.4 percent-the economy expanded at a more moderate 3.0 percent rate of growth in 2005. Global economic growth, high oil prices and export revenues, favorable external financial conditions, and increased domestic credit stimulated aggregate demand in all of its major categories-private consumption, investment, exports-raising economic activity and employment. 8. Continued price stability and increasing domestic credit have also contributed to the recovery. Price stability, sound public debt management and policies aimed at financial sector development allowed for a steady growth of domestic financial savings, whereas fiscal consolidation reduced the claim of the public sector on those savings thereby allowing for a sound expansion in domestic credit to the private sector. Since mid-2003, for the first time since the 1995 banking crisis, commercial banks' outstanding credit to the private sector has grown in real terms, leading to higher private consumption and business investment. In addition, the government managed to extend the domestic yield curve issuing longer term fixed rate bonds (up to 20 years), thereby creating an important benchmark for longer term private sector credit contracts, includingmortgage lending. 9. Inflation has come down after a substantial tightening of monetary policy. An increase of consumer price headline inflation in 2004, mainly attributed to supply shocks in the energy and food sectors, triggered a cycle of monetary policy tightening that lasted until mid -2005 and increased short-term interest rates to almost 10 percent annually. Consumer price inflation was effectively brought down from 5.2 percent year on year in December 2004 to 3.3 percent in December 2005, only slightly above the target of 3 percent. The successful reduction of headline inflation and inflation expectations allowed the central bank to start easing monetary conditions gradually throughout the secondhalf of 2005, bringingdown short term interest rates to 8.0 percent by the end of the year. 10. The government has kept the deficit within its annual budget targets and in line with its medium-term goal of fiscal consolidation. Higher than budgeted oil revenue has played an important role in achieving fiscal targets, compensating for lower tax revenue and higher public investment and revenue sharing with state and municipal governments. Oil-relatedbudget revenue has grown by a total of almost 2.5 percentagepoints of GDP over the past three years allowing the budget deficit to be cut by almost half that amount, though substantially increasing public sector dependence on oil revenue, which in 2005 accounted for 40 percent of public revenue. 11. A modest external current account deficit has been maintained throughout the recovery due to strong oil revenue and workers' remittances. The value of external trade resumed a double digit growth as of 2004 after its stagnation throughout the recessive 2001-2003 period. Mexican exports are closely related to the evolution of U.S. industrial production but face increased international competition as Mexico's share in US. imports lost ground over the past two years. Though the non-oil trade balance i s widening from a deficit slightly under 4 percent of GDP two years ago to a deficit close to 6 percent currently, the current account balance has kept a steady deficit at around US$ 8 billion or about 1 percent of GDP. In addition to rapidly increasing oil revenue, the current account is strengthened with strong and growing household transfers or workers' remittances. These transfers are estimated at almost US$ 20 billion for 2005 slightly over 2.5 percent of GDP, making up an important revenue stream in the country's external accounts and in the subsistence of poorer segments of Mexican society. 4 Medium-TermMacroeconomicProspectsandDebt Sustainability 12. Mexico's macroeconomic framework is solid Progress in attaining macroeconomic stability i s starting to pay off, with economic growth stabilizing around the economy's growth potential. Improvements in Mexico's sovereign credit risk ratings are another reflection of such progress and provide reasonable assurance of continued adequate access to external finance, even at times of increased market volatility. 13. Structural economic and competitiveness constraints and the prevailing legislative gridlock have reduced Mexico's potential output growthto slightly over 3 percent per year over the medium term. In addition, the favorable external conditions are unlikely to prevail over the next few years and the government's projection of 3.6 percent average annual GDP growth for 2006-08 may thus be difficult to attain. If the resolution of global imbalances were to result in a sharp slowdown in US growth, there i s a risk that the Mexican economy could be adversely affected. Other factors like slightly lower oil prices, higher international interest rates, and political uncertainty related to the presidentialelections and change in administration are likely to lead to a more moderate economic expansion over the next few years at an annual average growth of about 3.0 percent. 14. The government's medium-term fiscal framework aims to further increase fiscal consolidation and reduce public debt. The government's 2006 budget, presented in September, updated its medium-term fiscal projections for 2006-09. The projections include ambitious targets on the budget balance, with a small surplus in 2006, and a drop in off-budget financing. The fiscal consolidation envisaged in this framework would reduce net augmented debt to about 32 percent of GDP by 2009, from 41 percent in 2004. 15. Public debt management has diminished the exposure to refinancing, interest and exchange rate risk. A consistent implementation of the public debt management strategy aimed at reducing vulnerabilities and long-term financing costs has led to a significant strengthening of the government's debt structure. The increasing use of longer term fixed rate peso bonds has contributed to an important increase in the average maturity of domestic public debt. A gradual reduction of external debt, by at least US$ 500 million a year, has also been part of the debt management strategy for a couple of years to reduce the country's exposure to potential market vulnerabilities and external shocks. 16. Mexico has no Purchases and Loans outstanding with the IMF and maintains periodic bilateral discussions as part of the Fund's regular surveillance program. The last Article IV consultation was concluded by the IMF Executive Board on November 9, 2005. The Executive Directors commended the Mexican authorities for the improvements they had made in the economic policies, institutions and structures over the last decade, which have contributed to greater macroeconomic stability and reduced financial vulnerability. The challenge ahead will be to launch a new round of structural reforms that will enhance the economy's efficiency and competitiveness and ensure the transition to a more rapid growth path. The staff report, a Public Information Notice (see Annex 3) and a statement by the Executive Director for Mexico have been published in December 2005 and are available on the internet (www.imf.org). 111. THE OVERALL GOVERNMENT PROGRAM 17. The overall program of the current administration is set out in the National DevelopmentPlan2001-2006 (Plan Nacional de Desarrollo). This plan groups objectives, and the strategies for meeting them, into three broad areas: (i)social and human development; (ii) growth with quality; and (iii) order and respect. Table 1 below presents the principal objectives in each of these areas. 5 18. To meet the objective of managing the functioning of the economy responsibly, the National Development Plansets out an agenda that includes different aspects of financial sector reform. Specifically, the strategies outlined toward this goal are: (a) coordinate fiscal and monetary policies; (b) promote a new form of public financial management; (c) promote efficient arrangements for regulation and supervision in the financial system; (d) promote a solid and efficient commercial banking sector; (e) strengthen non-bank intermediaries and build a culture of insurance inMexico; (f) create a social banking sector; (g) strengthen the development banks; (h) foster efficiency in the capital markets; (i) promote productivity in the public sector; and Q) develop new instruments for risk control and the promotion of stability. Table 1:Mainobiecl 7es of the GoM's National Dc ,elopment Plan2001-2006 Social and humandevelopment Growth with quality Order and respect 1. Improve Mexicans' levels of 1.Manage the functioning of 1. Defend independence, sovereignty education and welfare the economy responsibly and national territorial integrity 2. Increase equity and equality of 2. Increase and extend country 2. Design a new strategic framework for opportunities competitiveness national security, in the context of 3. Promote education for the 3. Ensureinclusive democratic governance and development of personal development constitutional order capacities as well as of individual 4. Promote balanced regional 3.Contribute to political relations taking and collective initiatives development place in the framework of the new 4. Strengthen cohesion and social 5. Create conditions for democratic governance capital sustainable development 4. Build a relationship of responsible, 5. Achieve social and human balanced and productive collaboration development in harmony with among the powers of the Union and nature advance toward true federalism 6. Increase governmental capacity 5. Foster the capacity of the State to for responsiveness,to foster manage and moderate natural disasters citizens' confidence in institutions 6. Reduce corruption and make I absolutely transparent the management and performance of the federal administration 7. Guarantee public safety 8. Guarantee the swift and efficient exercise of justice, bound by the law and respect for human rights Source: Plan Nacional de Desarrollo, 2001 006, htttd/md.uresidencia.eob.mx 19. This proposed DPL has been designed to support the GoM's policy priorities for the financial sector. Table 2 presents the measures that would be included in the operation, divided according to which of the seven financial sector strategies above they would support. Complementary Bank Group activities -the coverage of which this program also accommodates- are also included. 6 Table 2: Banksupport for the GoM's financ Isector priorities Government strategy Areas covered inthis proposed DPLseries Other Bank Group support' Promote efficient arrangements Prudential regulation and Anti Money Laundering (AML) for regulation and supervision in supervision training the financial system Market disclosure Promote a solid and efficient Risk managementpractices commercial banking sector Solvency rules Strengthen non-bank Non-bank intermediaries to the intermediaries and build a culture capital markets of insurance in Mexico Promotion of competition and disclosure in pension funds Savings and Credit Sector Strengthening and Rural Microfinance (Loan 7 132-MX) Savings and Rural Finance - Bansefi Loan (Loan 7240-MX) ~Strengthen development banks Housing finance infrastructure Rural Finance Development Promotion of riskcapital industry Structural Adjustment Loan (Loan 7180-MX) FOVI Restructuring Loan (Loan 4443-MX) Foster efficiency in the capital New Securities Markets law Accounting and auditing ROSC markets Financial markets integrity Develop new instruments for risk New Securities Markets law control and the promotion of Enhanced risk management in stability commercial banks Strengthening of the derivatives markets 20. In addition, PRONAFIDE, the GoM's economic and fiscal program in support of the Development Plan, includes strengthening the financial sector and transforming the development banks as a central strategy. The expressed aim is to get a greater proportion of resources to flow through the financial system to all sectors of the economy. Overall, the National Program for Financing Development 2002-2006 (Programa Nacional de Financiamiento de Desarrollo, PRONAFDE) seeks to permanently strengthen sources of financing, through increasing the growth potential of the economy and guaranteeing a stable macroeconomic environment. Specific financial reforms highlighted in PRONAFLDE are discussed in the appropriate sub-sectoral sections below. In addition to financial sector strengthening, PRONAFIDE establishes four other key strategies: (a) implementation of structural reform and provision of infrastructure; (b) increasing public savings efforts; (c) stimulating private savings; and (d) using foreign savings as a complement to domestic savings. IV. KEY ISSUESINTHE FINANCIAL SECTOR GENERALCONTEXT 21. A decadeafter the Tequilacrisis, Mexico has a stable financialsector, though it hasleft segments of the populatiodeconomy underserved. Starting inthe late 1970s and for the following fifteen years, the Mexican financial sector experienced a series of boom and bust cycles in which the This support has been complemented by ajoint World Bank-IMFFinancial Sector Assessment Program (FSAP) carried out in 2002 which covered all areas of financial sector government strategy 7 bursting of credit bubbles led to the assumption by the public sector of substantial liabilities from the banking sector (through outright nationalization in 1982 or through bailouts of both lenders and debtors in 1995). During the late 1990s GoM's financial sector policies concentrated on avoiding a bank run in the aftermath of the Tequila crisis, cleaning up non performing loans of banks' balance sheets and generating the macroeconomic stability necessary to attract foreign capital into the financial sector. These policies in principle addressed the majority of the most pressing issues associatedwith banking sector stability. However, this process was accompanied by a dramatic fall in private sector financing by banks, dropping from a peak of 39.9 percent of GDP in 1994 - a level which was probably associated with an irrational bubble - to 11.5 percent of GDP in 2004. Figure 2 shows the current overall structure of the Mexican financial system. Figure 2: Distribution of assetsof the Mexican Financial System (Total Assets June 2005: US$397Bn) Warehousing, 0 l%q Bonding,0 2%+ I Factoring,0 3%11 Credit Unions, 0 4 LeasingCompanies, 0 5 O Brokerage Firms, 0 6% Non-Bank Financi Institutions 4 8'7 InsuranceCompan Mutual Funds, 10 1' Commercial Banks, 49 7% PensionFunds, 125O Development Banks, 135% Source: BdM, CNBV and CONSAR 22. Capital markets have failed to fill the financing gaps left by the banks. Domestic capital markets, includingequity and debt issuance, developed quickly duringthe first half of the 1990s when they went from financing less than 1 percent of private investment to more than 6 percent in 1993 before contracting as result of the crisis. Since then, domestic equity markets have been anemic, while the private debt markets have started to recover since 2003 and have supported the development of financing and investment alternatives for non-bank financial institutions and pension funds. On the other hand, in part thanks to a more stable macroeconomic environment, the government has been able to develop the local public debt market, reducing its dependence on foreign debt. This has helped to develop a benchmark yield curve which should help to facilitate the pricing and, therefore, expansion of private sector issuances. 23. Non-banking financia1 institutions and private pension funds are growing but still relatively small sources of financing. As a result of the North American Free Trade Agreement (NAFTA) the legal and regulatory framework was set up to allow the development of non-bank financial institutions, which cannot take deposits but fund themselves in the debt markets or through bank loans, including those from government-owned second tier financial institutions. These institutions (Sofoles, SociedadesFinancieras de ObjetoLimitado) have concentrated their activities in the housing sector, a segment largely abandoned by the banks in the aftermath of the crisis. By 2004 Sofoles's credit portfolios amounted to about 14.0 percent of the bank's loan portfolio and about 29.1 percent of the total housing portfolio. The pension funds created as the result of the 1997 pension reform (Siefores, Sociedadesde Inversio'n Especializadas en Fondos para el Retiro) are growing their assets under management at about 20 percent per annum and currently represent about 6.3 percent of 8 GDP. However, this important source of financing remains invested primarily in government debt (above 85 percent of total assets). 24. The dearth of financing vehicles also implies a lack of savings mechanisms for households and of adequate investment and hedging instruments for investors and firms, thus restraining growth and reducing employment opportunities. The limited depth of the financial sector not only constrains those demanding credit, it also hampers the ability to save and manage risks adequately, as a result of lower levels of competition and fewer incentives for the development of new financial products. The limited Siefores investment regime mandated by law, a natural result of its creation when the crisis was still fresh in policymakers' memories, prevented adequate diversification of risks. The limited demand by Siefores reduced development of new investment and financing mechanisms. A combination of a weak legal framework in some areas and over-regulation in others prevented the development of derivative instruments essential for risk management. 25. The shrinking of the financial sector after the last crisis has extended longer than expected, with a particularly negative impact on credit flows to the private sector. A bank run and a generalized failure of the financial system were avoided in the aftermath of the 1994-1995 crisis. The ensuing contraction of the sector was expected, as prudent behavior by government regulators and new investors reined in the exuberance of the past. However, ten years later, the financial sector remains relatively small compared to other countries inthe region (Figure3). In some cases, other parties outside the financial sector have filled gaps. For example, real sector industries are now a major provider of supplier finance as reflected by the Banco de Mexico's (BdM, the Central Bank) survey of enterprises and its balance of payments and credit flows analyses. But in many other cases, it appears that the lack of financing and investment vehicles has simply led to a loss of potential growth opportunities. Figure 3: Credit to the Private Sector in LatinAmerica 26. This contraction of the financial system has had an adverse impact on the overall competitiveness of the country. The ease, cost and efficiency with which businessescan access and manage financial resources have a major impact on the operation and investment behavior of firms. But the local productive sector is at a disadvantage internationally, in some aspects of the financial services available, particularly in the penetration of the financial system and the liquidity of the securities markets, according to a recent competitiveness study. (Table 3). 9 Table 3: Assessmentof comDetitivenessfor finance Mexico's competitiveness(2002) interms of: Rating from0 (worst) to 100 (best) Penetration of private financial system 3 Quality of banking sector and finance 67 Competition in the banking sector 91 Degree to which domestic banks face competition from foreign institutions 48 I Liquidity of securities markets 12 Long term bank lendingrates I 90 Source: Situacidn de la Comperirividud de Mekico 2004, Instituto Mexican0 para la Competitividad. ~//irnco.solutrends.corn 27. But this trend of decline in financial sector depth appears to be coming to an end. The recent resumption of economic growth and maintenance of low inflation has renewed banks' interest in lending, especially to households*. A more stable macroeconomic environment has led to lower interest rates and has encouragedthe creation of long-term fixed-rate loan products. Accounting rules and capital adequacy and loan classification requirements have improved considerably, while risk management standards have been introducedthat have enabled sound credit growth. Going forward, it i s expected that maintenance of a favorable macroeconomic environment, combined with recent improvements in credit infrastructure, will help the process of financial re-intermediation. 28. The recovery has been aided by improvements in the Mexican financial system's infrastructuresuch as the development of a well-functioningcredit bureau.As shown in Figure 4, the depth and quality of credit information in Mexico compares very favorably with regional peers. The information available in credit bureaus i s extensive, covering more than 33 million individuals and 1.4 million companies, which is estimated to account for more than 60 percent of the universe of possible borrowers. Although credit bureaus have been functioning since 1996, the introduction of a legal framework for the operation of credit bureaus in 2001 (Ley para Regular las Sociedades de Znfurmacio'n Crediticia), whose impact has been fully felt during the last two years, has broadened the universe of participating lenders3,enhanced the timeliness of data4, and strengthened the protection of personal data and information sharing. In turn, improved credit information, together with stronger loan classification rules, has allowed banks to better measure and manage their credit exposures as well as to reduce transaction and monitoring costs. Figure4: CreditInformationIndex (2005) Latin OECD Colombia Brazil Chile Mexico Amenca Note: The credit information index measures, on a scale of 0 to 6 (where higher i s better), the scope, access and quality of credit information available through public registries or private credit bureaus. Source: Doing Business (World Bank, 2005) This is evidenced by the purchase of several Sofoles by banks since late 2004, allowing banks to penetrate the middle- to lower-income residential mortgage market. Bank use of the credit bureau i s mandated by CNBV for all new loans. Creditors are required to update the information on their entire loan portfolio on a monthly basis. 10 29. Improved auditing and accounting standards have also contributed to a better credit information environment and greater financial performance transparency among listed companies and financial institutions. The Accounting and Auditing Report on the Observance of Standards and Codes (ROSC) carried out by the Bank in 2004 found that, during the last decade, Mexican Generally Accepted Accounting Principles (GAAP) have been converging towards International Financial Reporting Standards (IFRS). Local generally accepted auditing standards are also well developed although further steps are still required to harmonize them with International Standards on Auditing. In similar fashion, regulatory requirements for external auditors of credit institutions (amendments to Ley para Regular las Agrupaciones Financieras) have been introducedin 2005 that help to integrate external audits within the regulator's (CNBV) supervisory process. These rules allow the CNBV to influence the scope of the external audit, to have access to auditor work documents, and to be informed directly of any material findings. 30. Contract enforcement and creditor rights have also improved in recent years. There have been significant efforts recently to enhance contract enforcement and creditor rights in Mexico. A new bankruptcy law (Ley de Concursos Mercantiles) in 2000 streamlined commercial litigation processes, clarified creditor ordering during liquidations and reduced the possibility of opportunistic insolvency filings that had been used to the detriment of creditors. A set of legal changes to the collateral framework (Miscela'nea de Garantias) enacted in 2003 incorporated two new collateral mechanisms (non-possessory pledges on movable assets and the Guarantee Trust Agreement) and enhanced creditor rights by: (a) eliminating a burdensome non-recourse clause on pledges; (b) introducing new rules to expedite commercial procedures, which include harmonization of commercial litigation procedures across different states of the country under the Federal Code of Civil Procedures; (c) introducing out-of-court foreclosure procedures on security trust agreements (use of trusts as a vehicle of secured lending); (d) allowing the use of a blanket lien on assets to non-bank financial institutions; and (e) enhancing the collateral value of leased goods through enhanced repossessionrules. 31. The full impact of recent legal reformson creditor rights has not yet been realized. In the latest Doing Business Report (World Bank, 2005), the legal rights of creditors inMexico continue to compare poorly to those in other regional and OECD countries (Figure 5). This report is based on data collected in 2004 and hence may not reflect the full effect of the recent reforms. Furthermore, while the laws governing creditor rights have been reformed, the process to improve enforceability of laws and the credibility and impartiality of the judiciary system through better judge selection, training and compensation may take longer, especially given the wide heterogeneity of institutional contract enforceability across individual Mexican states. 11 Figure 5: Legal Rights Index and Cost of Contract Enforcement (2005) 7 , ,25 6 20 5 Legal Rights index 4 15 3 10 2 5 1 -Cost of 0 Contract Enforcement Mexico Brazil Chile Colombia OECD Latin (% of debt) America The legal rights index measures, on a scale of 0 to 10 (where higher is better), the strength of legal rights of creditors and their ability to promote access to credit. The cost of contract enforcement measures the cost of enforcing commercial contracts as a proportionof the actual debt. Source: Doing Business (WorldBank, 2005) 32. The G o M has designed a series of policy reforms to consolidate the renewed growth of the financial sector and continue strengthening the prudential regulation and market integrity to ensure sustainability. Given the history of previous financial crises and in spite of the significant advances that Mexico has made in strengthening its prudential regulation, the GoM has recognized that a reform program that concentrates on fostering the growth of the financial system without continuing to consolidate sector stability and market integrity would lack credibility, could have adverse effects or its impact could be set back if a financial crisis were to occur. Thus the program that would be supported by this DPL consists of reforms in three areas: (i)strengthening market integrity and prudential regulation to set the foundation for continued sustainable growth of the financial sector; (ii)increasing the depth, access and diversification of financing to foster a more effective role of the financial sector in the development of the economy; and (iii)promoting diversified investment instruments to complement the aim of increased financial access through enhancednational savings levels and investment vehicles. 33. The following sections describe in more details issues associated with each type of financial intermediary. This discussion concentrates particularly on issues related to the three policy reform areas to be supported by this loan. BANKINGSECTOR 34. Commercial banks continue to dominate the Mexican financial system, although non- bank financial institutions have progressively grown in importance. As shown in Table 4 below, the commercial banking sector accounts for more than 50 percent of the total assets in the financial system. However, its growth rate has lagged behind that of non-bank financial intermediaries such as Sofoles and Siefores, while its overall size remains relatively small (around 26 percent of GDP in June 2005). Changes in the legal and regulatory framework have facilitated the creation and growth of these non-bank financing vehicles, although they started from a low base and still represent a small share of the financial system'. In addition to the traditional financial system, there are a significant number of "social" or "popular" banking institutions such as credit unions and cooperatives, which are relatively small in size (estimated to hold about 55 billion pesos in assets or 0.7 percent of GDP) but are important interms of financial access for lower income households. ~ There i s some "pyramidization" in the financial system arising from financial linkages between the different sectors, s u c h as development b a n k s financing S o f o l e s . On the other hand, assets are u n d e r s t a t e d because the g r o s s amount of s e c u r i t i e s r e p u r c h a s e a g r e e m e n t s (repos) i s not included on the balance sheets. 12 Table 4: Mexico Evolution of the FinancialSystem (December 2001 June 2005) - - 2001 2002 2003 2004 Jun-05 CAGR 11 (in niillion of Mexican pesos) Total FinancialSystemAssets21 3,529,174 3,646,240 3,897,850 4,163,268 4,223,650 5.3% Commercial Banks 31 1.871.941 1.a73.673 1.993.656 2.141.993 2,124.85 1 3.7% DevelopmentBanks 31 626.245 592.474 569,791 541.683 530.204 -4.6% PensionFunds 293.700 363,284 433.308 492,641 534,607 18.7% MutualFunds 350.609 364.632 391.983 407.708 431.743 6.1% InsuranceCompanies 221.716 254.435 285.501 315.089 316.973 10.870 Sofoles 103.003 134.982 154.550 191.553 204,137 21.6% Other 41 61.960 62.759 69,055 12.602 81.136 8.0% (in percent of GDP) Total FinancialSystem Assets2/ 59.7 57.2 55.5 53.6 51.3 -4.2% CommercialBanks 31 32.2 29.9 28.9 28.1 26.3 -5.6% DevelopmentBanks 31 10.8 9.5 8.3 7.1 6.6 -13.2% PensionFunds 5.1 5.x 6.3 6.5 6.6 8.0% MutualFunds 6.0 5.8 5.7 5.3 5.3 -3.4% InsuranceCompanies 3.8 4.I 4.1 4.1 3.9 0.8% Sofoles 1.8 2.2 2.2 2.5 2.5 10.7% Other 41 (in million of Mexican pesos) Memo item NominalGDP 5.811.776 6.267.474 6,894,993 7,634.926 8.074.121 9,8% Source: Comisidn Nacional Bancaria ? de Valores, Comisidn Nacional del Sisrenia de Ahorroyparu el Reriro, Conrisidn Nacional de Seguros y Fianzas 11CompoundedAnnual Growth Rate( December2001 lune 2005) - 21ExcludingBancode Mexico 31IncludesFideicomisosand UDIS but excludesrepurchaseagreements(repos) 41Includescredit unions. brokeragefirms. leasingand factoring companies. warehousingandforeign exchangehouses 35. Substantial disintermediation has been apparent in bank balance sheets since the 1994- 95 Crisis. Disintermediation has occurred in both bank liabilities (financial savings) and assets (private sector credit). As Figure 6 shows, the share of bank liabilities to broad money (M2) has decreased, while the importance of public securities and pension funds (especially Siefores) has increased considerably. The recapitalization and restructuring of the banlung sector following the 1994-95 crisis and the introduction of mandatory defined-contributions pensions in 1997 have been key determinants of this shift in financial savings. On the asset side, bank credit to the private sector has decreased relative to GDP and to other sources of financing, although it has experienced a recovery inreal growth since 2001(Figure 7). 13 Figure 6: Mexico Composition of M 2 (1990-2005) - 4,000000 I 3500000 3 000,000 2500,000 --c 2,000,000 I 1500,000 1,000,000 500 000 0 r c m m o - r u m - m 7 m 7m 7m 7m 7m 7m 7 7 7 7 7 7 7m 7m 7m 7m Source: B d M Figure 7: Mexico -Financingto the Private Sector (1994-2005) 2 03c 010 1 509 C9C v) j: -5 3 - 1903oc3 5 5CO 300 I 0 IV 1994 II 1997 I1 1998 II 1999 II 2000 I12001 112002 112003 112004 112005 1 36. The commercial banking sector is highly concentrated in a few, mostly foreign financial institutions. As of June 2005, 6 out of the 29 commercial banks currently operating in Mexico controlled over 85 percent of total banking sector assets, with the top three banks accounting for 61 percent of total assets (Table 5). Many banks are owned by financial groups that are active in the full spectrum of financial sector activities, including pension fund management and insurance. Increased liberalization following the crisis has allowed foreign entry primarily via acquisitions, and foreign banks currently dominate the banking sector (82 percent of total assets). 14 Table 5: Mexico Ownership and Market Share of Largest Banks(June 2005) - Bank Ownership Share of Assets I/ Share of Loans I/Share of Deposits I/ (inpercent of total marker) BBVA-Bancomer BBVA Group (Spain) 25 28 28 Citibank-Banamex Citibank(USA) 21 19 19 Santander-Serfin BSCHGroup (Spain) 15 14 15 HSBC HSBCHoldings(UK) 11 11 13 Banorte Grupo FinancieroBanorte(Mexico) 8 9 9 Scotiabank-lnverlat ScotiabankGroup (Canada) 5 6 6 Inbursa Grupo FinancieroInbursa (Mexico) 4 5 4 All others nla 11 8 I Memo Item(in millionof Mexicanpesos) Total Assets/Loans/Deposits 2,124,851 1,118,480 1,410,045 Source: Comisidn Nacional Bancaria y de Valores 1/ As of June 2005 37. Banks' financial performance has improvedconsiderably in recent years. The banking sector reports adequate capitalization and increased profitability (Table 6). The sector's capital adequacy ratio has consistently remained above 14 percent, while both loan quality and profitability have improved considerably. Profitability is derived from relatively high lending spreads and service charges (especially on loans and remittances), as well as from the investment yield from mostly government securities. Banks remain heavily exposed to the public sector (almost 30 percent of total assets) for both their profitability and solvency. Table 6: Mexico Banking Sector FinancialPerformance Indicators(2001-2004) - 2001 2002 2003 2004 f rercentagel ASSET QUALITY Past Due Loansirotal Gross Loans l / 5.1 4.6 3.2 2.5 Loan Loss Provisionsirotal GrossLoans 6.8 6.7 5.6 5.3 LoanLoss ProvisionsiPas-due Loans 124 138 167 202 S0LVENCY Net WorthlTotd Assets 9.4 11.1 11.4 11.2 Capiral Adequacy Ratio 14.7 15.5 14.2 14.1 PROFITABILITY Returnon Average Assets (ROAA) 0.8 0.7 1.6 1.2 Returnon Average Quity (ROAE) 8.3 6.7 14.3 11.2 EFFICIENCY Cost-IncomeRatio (OperatingExpenses/ Gross Income) 62.7 66.8 62.2 62.3 OperatingExpenses/Average Assets 4.3 4.6 4.4 4.3 PUBLIC SECTOR EXPOSURE GovernmentSecurities/ Total Assets 8.4 8.5 15.6 17.4 GovernmentLoans / Total Assets 2/ 26.5 26.I 22.3 17.0 Source: Comisidn Nucronai Bancanay de Valores liLoanspastdue90daysormore 21 Includes loans to governmentagencies,FOBAPROA and IPAB 38. Credit growth has picked up considerably, albeit from a low base. Total bank lendingto the non-financial private sector rose from 8.2 percent of GDP in 2001 to around 10percent of GDP in June 20056, but remains significantly below its pre-crisis level. Most loan types exhibited positive growth, especially consumer lending, which has been increasing by more than 40 percent per annum since 2001 (Figure 8). In contrast, commercial loans have barely grown in real terms and have declined in importance over this time period. FOBAPROA (Fondo Bancario para la Proteccidn a1 Ahorro, Banlung Fund for Savings Protection) and JPAB (Znstituto para la Proteccidn del Ahorro Bancurio, Banking Savings Protection Institute) loans have declined primarily as a result of their This figure excludes loans to other financial institutions, public sector entities and restructured loans to FOBAPROA or IPAB, which totaled around406 billion pesos or 5 percent of GDP as of June 2005. 15 ongoing resolution and repayment, as well as of the agreement reached in 2004 to convert FOBAPROA notes into tradable IPAB securities'. Real annual growth rate of the banlung sector's performing loan portfolio had reached 30 percent as of June 2005, supported by the substantial pickup in the growth rates of both commercial loans (20 percent) and mortgages (45 percent) since early 2004. The primafacie paradox of substantial credit growth in spite of a still shrinking(as a proportion of GDP) banking sector can be explained by the loan asset re-allocationthat has been gradually taking place, away from FOBAPROA and PAB loans towards other loan types. Figure8: Mexico -Evolutionof BankLendingby Type (Dec. 2001 June 2005) - ,2w@yp __ __ __ __ __ ~ ~ ~ ~ ~ ~ ~ Financial .J/' ,.- Institutions 1,mm __ __ __,__ ,, C , Mortgages ~ ~ ~ c c ,'<` , c and __ I Government Agencies .-E .- - I4w.m 2w.m 0 December 2001 June 2005 Source: CNBV 39. Enhancingfinancialintermediationby commercialbanks,particularlyto firms, remains one of the most importantchallenges.As a result of the severe contraction in bank credit following the 1994-95 crisis, other formal (e.g. Sofoles, capital markets) and informal (e.g. "tandas") channels of credit have developed and proliferated. According to a BdM survey of corporate financing patterns (Figure 9), supplier credit has expanded at the expense of commercial bank financing in recent years. Since large Mexican firms are able to directly tap international capital markets, it has been the small and medium-sized firms that have borne the brunt of this adjustment. However, the emergence of a strong and profitable commercial banking sector provides a good foundation to revitalize financial intermediation going forward. Cross-border opportunities stemming from emigrants' remittances and the expansion of credit to underserved domestic segments will likely remain a priority for banks, which are eager to reach credit penetration levels that are comparable with those of regional peers. This is also desirable given the relatively small proportion of the population that is currently served 'These loans were granted as part of the banks' recapitalization and restructuring program that was carried out by the deposit insurance and bank restructuring agency FOBAPROA (IPAB's predecessor) following the 1994 crisis. Under this program, banks sold mostly impaired loans to FOBAPROA in return for promissory notes, but retained a downside risk if collections fell short of the sale value. Most of the FOBAPROA notes that were issued expire in 2005-2006. Under an agreement reached in July 2004 between SHCP, IPAB and the four remaining banks holding these notes (Banamex,Bancomer, HSBC - which acquired Bital - and Banorte),IPAB would issue new bonds to exchange most of the FOBAPROA debt under the same terms and conditions, once independent and final audits on all loans to be acquired by the IPAB took place. 16 by commercial banks'. Inthat respect, the likely entry of new, mostly niche banks in 2005-2006 i s a welcome development. Figure 9: Survey on Sources of Corporate Financing (1998-2005) 1 or^----__^---^--^^^ I I +Suppliers x-t^--Commercial Banks ,-Foreign Banks &Development Banks -All Other 1 40. Significant modifications in the legal and regulatory framework have supported the modernization of the banking sector in recent years. The main banking sector-related objectives of the 2002-2006 PRONAFIDE have been to strengthen banking regulations and supervision, revive commercial bank credit, encourage competition and innovation, and strengthen corporate governance structures. These have resulted in the implementation of an ambitious legislative and regulatory reform agendathat has included: Stronger prudential requirements, including on the requirements for external auditors of credit institutions (amendments to Ley para Regular las Agrupaciones Financieras) Establishment of a system for prompt corrective actions ("acciones correctivas tempranas") basedon banks' capital adequacy ratios (amendmentsto Ley de Instituciones de Crkdito) Introduction of new instruments and procedures to strengthen creditor rights (Misceldnea de Garantias) Improved disclosure and transparency of terms and conditions in various types of financial transactions (Ley de Transparencia y Foment0 a1 Crkdito Garantizado, Ley para la Transparenciay Ordenamiento de 10s Servicios Financieros) Regulation of the activities of credit bureaus and consumer protection issues (Ley para Regular las Sociedades de Informacidn Crediticia) Better corporate governance practices (amendments to Ley de Znstituciones de Crkdito) Combating money laundering and terrorism financing (Misceldnea de Lavado de Dinero y Financiamiento a1 Terrorismo) A series of CNBV (Comisidn Nacional Bancaria y de Valores, National Banking and Securities Commission) regulations strengthening and harmonizing risk management practices and internal control procedures, as well as improving prudential requirements, external audit standards, and financial transparency and disclosure. *Branch penetration i s relatively low (around 12,500 inhabitants per commercial bank branch), while it is estimated that around 20-25 million people, or less than 50 percent of the economically active population, hold commercial bank accounts. 17 41. Prudential and developmental issues will continue to dominate the policy reform agenda going forward. On the prudential dimension, the authorities will need to ensure that credit growth remains sound and does not compromise the quality of bank loan portfolios. Given the structure and characteristics of the banking sector (presence of large, mostly foreign, financial groups), the effective implementation of Base1 I1 Accord on capital adequacy and the development of a consolidated supervision framework are high on the supervisory agenda. In addition, the development of alternative banking resolution mechanisms is an important policy priority to provide more flexibility to policymakers in cases of bank distress. On the developmental dimension, greater and lower-cost access to basic banking services remains an important consideration to support the process of financial re-intermediation. 42. Over the last decade, the role of public development banks (DBs) has progressively diminished and by March 2005, accounted for just 5 percent of all sources of financing for the private sector (including loans through private financial intermediaries). Measures to reform and improve the efficiency of the DBs started in the mid-1980s. However, the most far reaching reforms started in the 1990s, when the GoM required DBs to purchase resources in the market and focus on "second-tier'' lending activities and extended to them the prudential regulations that applied to private banks. Subsequently, in mid-2002, the Credit Institutions Law, and the charters of all the development banks were amended to: (i)establish that the objective of DBs i s to promote the development of the productive sectors, but preserving their capital, while reducing or eliminating their capacity to provide unlimited subsidies; (ii)provide DBs with greater autonomy of operation, but in exchange require from them better governance and greater transparency and accountability; (iii) eliminate management discretion in the determination of pension benefits to their employees; and (iv) reduce the excess of regulations. 43. These legal reforms to the DBs were complemented with drastic institutional changes with substantial Bank support. The Bank supported, with separate lending operations and analytical work described in more detail in Section V below, three major structural changes to the Mexican DBs: 0 The liquidation of Banrural and its replacement with Financiera Rural (FR), a non-bank financial institution in charge of developing rural financial markets and lending to rural activities. FR had an initial capital endowment of MX$17.5 billion, and cannot mobilize deposits or issue debt. Its charter obliges it to maintain in real terms the value of its capital endowment dedicated to lending, and, over time, to move towards second-tier lending. After two years of operations, FR represents 15 percent of rural credit, and for the first half of 2005 it had positive operational results, with a Returnon Assets (ROA) of over 4 percent. Its level of non-performing loans i s 3.3 percent. 0 The creation of the National Financial Services Bank (Bansefi, Banco Nacional de Servicios Financieros), on the basis of the previously government-owned Trust for National Savings (PANHAL), with the mission of promoting savings among low income groups though the development of popular savings and credit institutions. 0 The creation of Sociedad Hipotecaria Federal (SHF), with the transformation of FOVI, a housing trust fund managed by the Central Bank. SHF i s a national mortgage bank in charge of promoting primary and secondary housing financial markets. It provides second-tier credit for housing finance to banks, finance companies (Sofoles), and trust funds. 44. The GoM will continue targeting DB's activities toward areas in which they can facilitate the proper operation of the private financial sector though they will keep an important role as the government's financial agent. DBs have an important role as a financial vehicle for the 18 Government, including being financial agents of the Federal Government and passing-through external credits from internationalfinancial institutions. NONBANK FINANCIAL INSTITUTIONS AND HOUSINGFINANCE 45. Most non-bank financial institutions, Sofoles, have focused on residential mortgage lending to moderate and middle income households, an area from which commercial banks withdrew in the wake of the 1994-1995 financial crisis (Figure 10). The Mexican mortgage market grew rapidly in the past five years, in contrast with its collapse after the crisis of the mid 1990's. In the wake of the crisis, high default rates and falling house prices led to the almost complete withdrawal of commercial banks from residential mortgage lending. In their place Sofoles rose to provide mortgage financing for moderate and low-income households. Sofol lending has been mostly financed with lines of credit from the federal government, first from FOVI, a trust fund managedby the BdM, and since 2002 by SHF, a government-owned development bank created with FOVI's assets to promote the creation of private sector primary and secondary mortgage markets. SHF is a second- tier bank that offers lines of credit, mortgage default insurance (MI), and credit enhancements for pools of mortgages, with a focus on mortgages to moderate and low income households. The other major primary lenders in Mexico are INFONAVIT and FOVISSSTE, government-owned provident funds created to provide mortgages to private and public sector employees, respectively. Commercial banks have resumedlendingto upper-income segments. Figure 10: Distribution of Sofoles by Type (March 2005) Source: Comisi6n Nacional Bancaria y de Valores 46. Mortgage Sofoles' more labor-intensive business model and more flexible underwriting standards have permitted them to succeed in lending to segments that banks traditionally have ignored. Using SHF funding, Sofoles have targeted households that earn between three and eight times the monthly minimumwage, many of whom are informally employed, a segment that has been characterized as the urban working poor. In cooperation with developers, Sofoles set up origination and collection offices in the center of new housing developments targeted at this segment. As verification of the capacity to pay for informal workers, Sofoles accept alternative documentation such as receipts for rent and utility payments. Once a loan is originated, the Sofol collects it using employees located in the housing development, who stay in touch with each of the borrowers. This business modelis distinct from that of commercial banks, which target formally-employed individuals with incomes greater than seven minimumwages, and rely on more traditional means to collect, such as mailed notices and phone calls. Sofoles pay for their more expensive business model by charging higher interest rates than banks, but they have maintained cumulative default rates over the past ten years of between 1and 3 percent, which are quite manageableby international standards. 47. The housing market is now characterized by a system-wide loan portfolio that has reached about 11 percent of GDP, comparable with Chile, but much lower than wealthier 19 countries in North America or Europe. The sector depends on continued, substantial support from the public sector. Default rates are low (between 1and 3 percent cumulative defaults for most mortgage Sofoles), interest rates are moderate (around 11 percent at commercial banks and government lenders, a bit more at Sofoles for 15 year, 80 percent loan-to-value (LTV) loans), and securitization has begun (12 transactions in the past two years). SHF's mortgage default insurance (MI)product permits loans of 85 percent and 90 percent LTV, increasing affordability for moderate- income borrowers. Indices of mortgage affordability have improved. For example, the cost of financing a median priced house has fallen from a level of 5.6 times the median annual income in 1995 to 1.1 times in 20049.While this implies that a median house remains out of reach for a median income family, the gap i s much reduced from the time of the crisis. However, most low-income households are not served by the formal financial sector, and lacking credit, rely instead on self- constructionand informal title and ownership. 48. Although it has proven politically difficult to end long-standing direct lending programs, on the margin the government is designing programs for housing finance that promote private sector involvement and that leverage private sector resources. Past policies focused primarily on inefficient direct lending programs that continue to distort primary markets. Important remaining programs from this era are INFONAVIT and FOVISSTE, as can be seen in Table 7. The presence of labor unions on the board of these institutions has limited reforms to their lending programs, and they continue to dominate the market, originating more than 62 percent of loans in 2004. However, recent government policies have led to the increased influence of SHF MI and securitization programs. SHF funding of Sofol lendinghas been the primary source of funding for low and moderate income lending over the past ten years. The strong performance of SHF-funded mortgages, in conjunction with improvements to foreclosure processes, economic recovery, and macroeconomic stability have attracted commercial banks to come back to mortgage lending, originating more than 55,000 loans inthe first 10months of 2005, versus about 3,000 in all of 1998. 1998 1999 2000 2001 2002 2003 2004 2005(Oct) INFONAVIT 11 108,035 198,950 250,l10 205,346 275,000 300,000 305,975 280,669 SHF 21 55,425 59,118 46,704 47,555 46,136 54,229 65,320 44,206 FOVISSSTE 15,323 17,862 24,301 26,641 11,068 68,168 60,252 23,729 BANKSand SOFOLES 31 3,269 865 1,101 3,707 9,735 17.648 35,772 55,327 Other 41 12,139 7,114 10,199 8,750 4,309 12,284 121,281 43,249 182,052 276,795 322,216 283,249 341,939 440,045 590,604 403,931 49. The Mexican government has sought to create a legal and regulatory framework that encourages the private financial sector to serve as much of the population as is feasible. For the lowest income segments, the government i s working to design and implement efficient and equitable subsidy programs. The government has sought to use agencies such as SHF to demonstrate the feasibility of financial products, and then withdraw from markets once private sector providers have entered. SHF has done this with residential construction finance, which banks were unwilling to provide after the crisis. SHF first provided direct credits to developers, then moved to guarantees for bank and Sofol credits, and then gradually reduced the balance that it would guarantee. SHF also provided financial guarantees for construction loan securitizations. Now, banks lend to developers without the SHF guarantee, and Sofoles have securitized construction loans and sold the resulting bonds in the UnitedStates, also without SHF support. BBVA Index of Mortgage Costs inMexico 20 50. SHF is leading the government's efforts to increase private sector participation in residential mortgage finance, given the persistent housing deficit. While mortgage production has risen, a housing deficit remains of 4.2 million units, and production still falls well short of the government's target of 750,000 new housing units per year, a pace that would match that of new household formations. By law, SHF will close its line of credit in 2009, at which time Sofoles will either have to securitize their portfolios or change their business models to become more like mortgage brokers, which originate but never hold mortgages. To promote securitization SHF offers MI for individual mortgages and financial guarantees for pools of mortgages. To promote private sector participation in MI and financial guarantees, SHF has proposed legal changes that would permit insurance companies to offer each of these products. Within a few years, the Mexican market should operate with SHF providing MI and financial guarantees for low and moderate income borrowers, and the private sector financing moderate and upper income borrowers with similar products. 51. With respect to the roles of INFONAVIT and FOVISSSTE, the government's focus to date has been on operational reforms and improvements to governance and transparency. Each serves three conflicting roles: direct lender, subsidy provider, and pension fund. Both institutions have had a long history of financial losses, poor operational performance, and political interference. INFONAVIT has made the most progress in reforming financial operations. In the third quarter of 2005, defaults were 8.6 percent of the total portfolio, much improved from the 21.7 percent experienced in 2000. Salary contributions, which in the past kept the institute afloat, made up 44.3 percent of cash inflows in 2004, will makeup 41 percent of inflows in 2005, and since new loans are priced closer to market, and presumably will be collected, cash inflows should continue to grow with time. INFONAVIT's organic law was amended in January, 2005 to improve its governance structure by involving external financial professionals in audit and risk committees. However, the government has not yet directly addressed the role of these state-owned and privileged institutions in affecting the supply of private sector financing to low and moderate-income borrowers. There remain substantial issues with respect to the strategic roles of INFONAVIT and FOVISSSTE in the mortgage market, and the efficiency and equity of the subsidies that they provide. 52. Reform of the strategic role of INF'ONAVIT and FOVISSSTE should support the development of a fully private primary market, the elimination of subsidies to upper-middle income borrowers, and more efficient public assistance for low income borrowers. Management of INFONAVIT is not permittedto structure its loan products or set prices in a way that would allow it to mitigate financial risk and so manage safely and efficiently. Sub-market pricing results in inequitable and inefficient subsidies. While 78 percent of INFONAVIT members earn less than 4 monthly minimumwages, half of INFONAVIT loans are made to members that earn more than seven monthly minimum wages, a sector served by both banks and Sofoles. In effect, low-income INFONAVIT savers sacrifice a portion of their pension savings to subsidize loans to individuals who could borrow from the private sector at market rates. The government has commissioned a strategic study of INFONAVIT and FOVISSSTE and their roles in the housing finance market that i s planned to be completed by March, 2006. An agenda for the reform of INFONAVIT and FOVISSSTE should include: pricing and designing products on commercial terms, the re-design of the subsidy component of its products to be an explicit, up-front, demand-side subsidy harmonized with other government subsidy programs (Tu Casa and PROSAVI), and evolution from direct lending to acting as a second- tier institution or purchaser of mortgage-backed securities. CAPITAL M A R K E T S 53. Mexico's government recognizes that more effective capital markets and a broader range of financing instruments are essential to provide companies with the resources they require to invest and expand. New financing alternatives - primarily risk capital (private equity and 21 venture capital) - are particularly important for small and medium sized enterprises. While these firms represent the seeds of growth of the economy, they have little access to capital from banks or markets. From the demand side, there is also a need to expand the range of investment possibilities for individuals and institutional investors. 54. Mexican authorities have taken important steps to bolster the country's capital markets in recent years, with a focus on improving corporate governance. In particular, the 2001 Securities Market Law (Ley del Mercado de Vulores) revised much of the legal framework, eliminating some legal hurdles and inconsistencies. In the area of corporate governance, it reformed voting rights and the structure of boards of directors, strengthening the rights of minority shareholders. For example, the law restricts the issue of non-voting shares - often previously the only ones available to outside investors - to 25 percent of the float of a public corporation. The securities regulator (Cornisidn Nacional Bancuria y de Valores, CNBV) has subsequently issued further regulations to increase transparency and disclosure and reform other areas, such as the rules on tender offers (April 2002). 55. Supervision and institutional arrangements have been strengthened. The 2001 law granted stronger inspection and enforcement powers to the CNBV. In addition, the basic infrastructure of the markets has been upgraded, with the improvement of custody, clearing and settlement arrangements and the introduction of independent price vendors. A rulebook for securities issuance has been published, and additional guidelines issued on insider trading and accounting procedures, among other matters. 56. Other significant achievements include the development of the benchmark local currency yield curve, through federal debt instruments. After the 1994-1995 crisis, the federal government followed a proactive debt management strategy, to develop the local currency debt market, and reduce the vulnerability of its debt to interest rate and foreign exchange risks. Helpedby a more stable macroeconomic environment with lower interest rates, and within an overall context of reducing public indebtedness, the government has issued increasingly on the domestic bond market, introducinglonger tenor fixed-coupon bonds. Whereas outstanding domestic federal government debt represented7 percent of GDP in 1994, the level had risen to 14 percent by 2004". The local currency yield curve (Figure 11) has lengthened to 20 years, establishing a benchmark that facilitates private and sub-sovereign issuance. The growth of domestic federal bonds does pose, however, a risk in terms of crowding out private issuers, in as much as the former have grown to become dominant investment instruments, attracting a significant proportion of national savings. The government continues its efforts to strike a balance between strengthening public debt risk management and fostering increasedprivate sector access to financing. loThis does not includeIPAB debt. 22 Figure 11: Evolution of the Federal Government Yield Curve - -1999 I 2000 +2001 I 0 1 1 2 3 4 5 6 7 8 9 1011121314151617181920 Maturity(years) Source: SHCP 57. The local-currency denominated corporate debt market has expanded recently, but remains small. The Certifcado Bursdtil, introduced in 2001 in the Ley de Sociedades de Inversidn, has played a key role here. As issuers understood the full flexibility of this debt instrument, it has been increasingly used by firms and sub-sovereign entities for structured solutions such as asset- backed securities, given the possibility to raise the financing before the actual move of the assets to the special purpose vehicle. Overall, peso-denominated private bonds outstanding exceeded US$ 20 billion in 2004, up from US$593 million in 1996 (Figure 12). However, this represents only about 2 percent of GDP and while the average tenor is around 3.5 years, the proportion of floating rate debt i s high. Figure 12: Evolution of the Domestic Corporate Bonds Outstanding I I 25 20 $ 15 clt v) 2 '0 5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 I i Mother instruments 0 Certificados Bursatiles Source: SHCP 58. Another positive development is the growth of a vigorous derivatives exchange, which allows the diversification and mitigation of risks. Mexico has around 100 years of experience with unregulated over-the-counter (OTC) derivatives. These include mature foreign exchange derivatives products, as well as fast growing interest rate derivatives (Figure 13). An organized exchange for derivatives contracts -MexDer- was only created in 1998. Trading activity picked up significantly from 2001 onwards, especially for short term interest rates futures, fostered by the development of the peso yield curve and improvements to market infrastructure. As illustrated by Figure 14, even when including offshore trading of Mexican Peso derivatives (roughly 50 percent of foreign exchange OTC and 20 percent of interest rate OTC), MexDer interest rate futures daily turnover is noticeably high, only exceeded by the foreign exchange swaps volumes. In 2004, MexDer expanded its equity-related business by starting trade in stock options, stock futures, and index options. By that year MexDer had 23 become the fifth most active futures exchange worldwide, and the third for short term interest rate futures. Figure 13: OTC ForeignExchange and Interest Rate DerivativesDaily Turnover in Selected Emerging Markets Foreign Exchange Derivatives I 12,000 10,000 .-6 -.-E 8,000 6,000 fft 2 4,000 2,000 G+w ."",.$ @*psC* ,& .$ &' @*@Q*+Go G." +@ ?$4-"' .Jo Interest Rate Derivatives 3,500 3,000 !z! ''4 2,500 2,000 1,500 1,000 500 Source: Bank for Internatior Settlements Triennial Survey Figure 14: Consolidated (domestic & offshore) Daily Turnover of MexicanPeso Derivatives OTC and Exchange-traded", by product (2004) 8,000 7,000 -e 6,000 .P 5,000 'E 3 4,000 = 3,000 2,000 1,000 0 Source: Bank for InternationalSettlements Triennial Survey and BdM 59. However, Mexico's equity market remains relatively small and illiquid, and is not a major source of financing for most companies. Of the eight largest economies in the Americas, l1In addition to MexDer, the ChicagoMercantile Exchange also lists two futures contracts on Mexican Peso interest rates, but there has been no activity recently. 24 Mexico has the second smallest stock market, relative to GDP (Figure 15). The free float is limited and trading volumes are also low. The stock market displays a high level of concentration, with the top 10 companies representing close to 70 percent of market capitalization. Ownership of listed firms i s also highly concentrated, and listed firms may issue different types of non-fungible shares in order to avoid dilution of corporate control, which fragments the securities market and reduces liquidity. Figure 15: Market capitalization of listed companies,End-2004 (Percentage of GDP) 160 140 120 100 80 60 40 20 0 I Source: World Bank World Development Indicators 60. While a surge in the index has raised market capitalization, the equity market has been shrinking by other measures. Market capitalization increased to US$ 216.8 billion at the end of September, up46 percent from a year earlier. But Mexico had only 149 companies listed at the end of September 2005, down from 206 at the end of 1994. There were only 5 new equity issues in 2004, a sharp decline from 100 in 1994. However 2005 has shown a slight increase, with 7 new issues in the first nine months of the year (Figure 16). Figure 16: Number of listed companiesand new equity issues 250 120 ~ 200 No.of listed -- 100 .E v) -- 80 150 m $ P -- 60 E 100 8 v) New equity .-$ -- 40 50 issues per year - 20 I o-, , 0 I I *t I 1994 1996 1998 2000 2002 2004 Source: IFC Emerging Markets Database 61. Larger companies have increasingly preferred to list on international markets. This has usually taken the form of cross listings in the U.S. market, through American Depositary Receipts (ADRs). In 2000, almost half of listed firms had a foreign listing or had raised capital abroad, and 25 trading in foreign stock markets exceeded domestic trading. Outstanding ADRs reached US$ 48.9 billion inMay 2005, equivalent to more than 20 percent of Mexican market capitalization. 62. Insufficient risk capital12is available. According to industry estimate^'^, Mexico accounts for only around 0.1 percent of the overall risk capital investments globally and 10% of risk capital in Latin America, over the last ten years. A number of obstacles continue to impede the industry's growth, particularly with regard to early-stage small and medium enterprises investments, including the absence of a pass-through investment vehicle, the legal constraints on shareholders' agreementsto protect minority stakes, the restrictions on participation by domestic institutional investors, and the low probability of stock market-driven exit strategies. 63. The institutional and retail investor base has been expanding, but still has great potentialfor further growth. The 1997 pension reform created an institutional investor base, which has gradually been growing and reached 6 percent of GDP in 2004. Pension funds administrators (Administradorus de Fondos para el Retiro, Afores) have been gradually permitted to invest in different assets and issuers, giving impetus to those markets. Mutual funds (sociedades de inversion) have also grown substantially since the 2001 reform to the Ley de Sociedades de Inversion, exceeding 5 percent of GDP in 2004. Life insurance and annuities companies will also be growing, though much more slowly initially, given their role inthe payout phase of the pension system (Figure 17). Figure 17: Evolution of Mutual Fundsand Siefores Assets (US$ million) 50,000 ~ 40,000 - 30,000 ~ 5.- v) E b3 20,000 u) = 10,000 ~ 0 I 1998 1999 2000 2001 2002 2003 2004 W Mutual Funds OSiefores Source: MexDer Through the Mercado Global (Global Market), Mexican authorities have been seeking to foster asset diversification among local institutional and qualified investors by providing easy access to international securities. The system, operational since 2003, allows Mexican investors to trade a pre-approved set of foreign securities or indices on the local stock exchange, denominated inpesos. It i s based on the legal and regulatory framework of the "international quotation system" (Sistema Zntemacional de Cotizaciones),developed by SHCP, CNBV and the Mexican Stock Exchange. Use '*Risk capitalinvestments refer to money provided by individuals and professionally managed funds that invest alongside managementin growth-oriented companies. This spans (i) seed capital, investments made at the earliest stage of company formation; (ii) venture capital, investments made at an early stage of a company's development but after some track record has been established, and (iii)private equity, later stage investments which tend to be larger and in more sophisticated companies. l3"Review and Action Plan for Development of the Venture Capital Industry in Mexico", funded by U S Trade Development Agency, and supervised by NAFIN(2003). 26 of the Global Market has been increasing slowly, but remains slight, with outstanding investments of US$ 280 million in early 2005, for 190 listed securities and 12 exchange-tradedfunds. This initiative has therefore not yet contributed significantly to deepening the domestic financial sector. For qualified investors, the Global Market's main advantages are fiscal incentives (capital gains tax exemption and 10 percent tax on dividends) and operational simplicity (all can be done through the account with the local broker). This also provides a new line of business to local brokers and stock and derivatives exchange^.'^ However, the Global Market initiative might add to the transaction costs (through the addition of domestic brokerage and currency conversion costs on top of foreign brokerage costs). It could also lead to a crowding out effect for domestic issuers, in case it succeeds to channel more Mexican savings to foreign securities. PRIVATE PENSIONS SYSTEM 64. The private pensions system was created in 1997 through a reform to the Retirement Savings System (Sistemade Ahorro para el Retiro).The reformreplaced the Pay as You Go System (PAYG) with an individual capitalization system for private sector employee^'^. The Afores were established as the companies in charge of managing the individual accounts and Siefores would invest pension funds in financial instruments, on behalf of the account holders. The main role of the Government in this system is to supervise and provide some guarantees. With respect to Supervision, the CONSAR (Comisio'n Nacional del Sisrerna de Ahorro para el Retiro) is the agency in charge of the regulation and supervision of the system.16 Among the government's commitments, the most important are a minimum pension guarantee17 and allowing the possibility of choosing between benefits of the new and the old system, for the generations that contributed to the old system. 65. The system in Mexico combines inthe Afore accounts the provision of different services: housing, old age unemployment and retirement. Voluntary saving i s also possible under this system: the employer or employee can contribute to these accounts on a voluntary basis. The compulsory accounts receive contributions from the employer, employees and the government (the Cuora Social, which is 5.5 percent of the minimumwage). Inthe case of housing accounts the funds are directly managedby INFONAVIT. 66. Eight years after the reform, funds under management have increased significantly, from less than 2 percent of GDP in 1998 to more than 10 percent in 2005. This increase i s mostly driven by obligatory pension savings, which increased from less than 1 percent to almost 7 percent of GDP (Figure 18). There has also been a major increase in the number of accounts from 11million in December 1997 to more than 34 million in 2005. l4MexDer i s also benefiting from the Global Market, which supports the trading on some of the new option contractsrelatedto ETFs. l5The Public Sector remainsin aPAYG system. l6CONSAR has a consultativecommittee and governing board, in which workers, employers and the government participate. 17 The minimum pension guarantee i s equivalent to the minimum wage, but the worker has to be 65 years old and have made at least 1,250 weekly contributions to qualify. 27 Figure 18: Evolution o f Assets inAfores (Percentage of GDP) 12 006 0VoluntarySaving IIHousingFund May198 Nod98 MaylY9 Nov199 May100 Nuvl00 May101NovlOl May102 NovIOZ May103 Novl03 MaylC4 Novl04 May105 67. Though the level o f participants remains limited, the reforms have contributed to an increase in labor force participation in the system. The number of participants in the Mexican pensions system has increased since the 1997 reform in a trend similar to that observed in other countries in the region to about 60 percent of the economically active population from about 40 percent before the reform. The challenge i s to allow this coverage among the labor force to increase in order to address the very low level of beneficiaries from pensions, standing at about 20 percent of those above age 65, low even by regional standards (Figure 19). While part of the reason behindthe low coverage i s related to the overall structure of the labor markets and the high level of informality, recent analytical studies support the idea that increasing competition among pension administrators and providing better disclosure of investments performance increase the level of sense of ownership by participants and ultimately increase their savings levels.'*. Figure 19: Pension System Coverage inLatinAmerica 1 Contributors/konornicaliy Active Population 0 Beneficiaries/ hpulation over 65 I Note: Countries that have compulsory individual capitalization systems are Argentina, Bolivia, Chile, Costa Rica, ElSalvador, Mexico, Peru and Uruguay. Source: Rofman (2005) 68. The G o M has carried out a process o f reforms in the last three years, to liberalize the Siefores' investment regime, boost competition and increase transparency for workers. As in '*Seefor example, evidence from the Social Protection Survey conducted in 2002 in Chile, www.proteccionsocia1.cl. 28 other countries that undertook similar reforms, the initial private pension regime was very restrained due to concerns associated with safeguarding workers' savings from volatile investments. This prevented a better alignment of the risk appetite of workers according to their stage in the life-cycle (i.e., willingness to incur higher risks in exchange for higher long term returns during their younger years, and lower risk tolerance as they get closer to retirement age). Failure to allow for this changing risk aversion can ultimately leadto inadequatereturns." 69. Until December 2004, pensionfunds in Mexico could only be invested in fixed income instruments, leading to a concentration in government debt. In fact, given the short supply of corporate instruments of this kind in Mexico, among other reasons, more than 85 percent on average was invested in government issued paper between 1998 and 2004. This was the case in spite of regulatory changes that had taken place since 2002, seeking to foster a broader range of investments. These reforms had included: (a) Removalof the minimuminvestment limit for government issued instruments, which hadbeen set at 65 percent; (b) Removal of the 35 percent maximum investment limit for the private sector; (c) Removal of the 10percent maximum investment limit for financial institutions; (d) The riskrating floor for instruments invested inwas loweredto A from AA; (e) Investment ingovernment instruments denominated in currencies other than dollars was allowed; (f) Investment in derivatives was also permitted for the first time; and (g) The requirement that at least 65 percent of investments have duration of less than 182 days was substituted for a weighted average duration limit of 90 days and afterwards replaced by a VAR of 0.6 percent. V. BANK SUPPORTTO THE GOVERNMENT'S STRATEGY LINKTO CPS 70. In fortifying and diversifying the financial sector and capital markets, and easing the flow of financing to businesses, the proposed loan aims at increasing competitiveness, the pursuit of which is the first thematic pillar of the Bank's Country Partnership Strategy (CPS) for Mexico, which covers the periodFY05 to FY08. The Bank strategy, as expressed in the CPS report 28141-ME dated March 18, 2004, which was discussed by the Executive Board in April 2004, has three other principal pillars: a) reducing poverty and inequality; (b) strengthening institutions; and (c) promoting environmental sustainability. The proposed loan would also advance toward the first of these, by promoting equitable economic growth, which createsjobs and reduces poverty (as discussed in the section on poverty and social impacts below). In addition, the program includes elements of institutional strengthening, particularly in enhancing the supervisory capabilities of authorities in the financial sector. l9 Berstein and Chumacera2004 show that for the case of Chile, which had a more flexible regime, investment limits had an important impact on pensionfund returns. 29 71. In particular, this DPL series will contribute to the achievement of medium-term country targets linked to four elements of the CPS. These elements are: (i) support efforts to enhance market efficiency and increase competitiveness; (ii) improve corporate governance and social responsibility; (iii) develop financial markets, improve access to financial services, and expand property ownership opportunities; and (iv) support efforts to provide broader access to low-income housing and landownership. 72. The CPS lending program envisages a $300 million financial sector loan for FY2007, with an emphasis on promoting access to financial services. However because another Bank operation (the Second Savings and Rural Finance Project) already focuses on improving access, the DPL proposed here instead pursues a broader program of financial sector strengthening and diversification, to promote stronger economic growth. The total amount has been increased to US$501.26M and the timing advancedat the request of the GoM. COLLABORATIONWITH THE IMFAND OTHER LENDERS 73. IMFandBankstaff maintainaregular exchangeonmacropolicyinMexico. There is no IMFprogram in Mexico. The Mexican government does maintain an active policy dialogue with the Fund, however, through the Fund's bilateral and global surveillance activities. This summer, under Article IV of the IMF's Articles of Agreement, the IMF held bilateral discussions with Mexican authorities which were presented to the IMF Board in early November 2005. No major issues or disagreementswere reported. 74. The Inter American Development Bank (IADB) is implementing a two-tranche US$600 million Financial System Consolidation Policy Loan (FSCPL). That loan supports some of the reforms that the GoM has carried out in the areas of prudential regulation, markets integrity and public debt management. Inaddition to the overall dialogue between the two institutions in Mexico, the Bank staff preparing this operation has met periodically with the IADB team supervising the implementation of the loan to ensure consistency in the policies supported by the two institutions. Additionally, the IADB approved in November 2005 a line of credit and technical assistance to Bancomext, the government-owned export promotion financial institution, to foster its role as a second tier bank that lends funds to private financial institutions to support export-oriented small and mediumenterprises. 75. The FSCPL's three areas of policy support includeareas that complement this proposed DPL. These areas are: Financial Institutions Regulation: This component supports many of the policies that this proposed DPL supports in its first loan and seeks to provide a solid prudential foundation on which to basethe growth of the financial sector. The second tranche of the IADB operation would support additional strengthening of financial institutions internal credit processes, an effort that will complement the policies that the second loan of this DPL series would support in the area of increased disclosure and solvency rules of financial institutions; Capital Markets: The FSCPL supports the passage of the Securities Markets Law and the issuance of the regulations that will facilitate its implementation. Those regulations will, inter alia, support the development of the housing and non-bank finance infrastructure as well as provide a better investment environment for private pensions funds, policy areas that this DPL would support with its second loan; and Public Debt: Enhanced public debt management, including the development of a strategy for debt issuancethat seeks to extend the tenor of debt, i s essential for further 30 development of private sector capital markets. Therefore, FSCPL's support for enhanced public debt policies facilitates the development of capital markets to be supported by this DPL. RELATIONSHIP TO OTHERB A N K OPERATIONS 76. Several ongoing or recently completed Bank lending operations and analytical work in the financial sector and in economic competitiveness complement this operation (see Table 2). These include several policy-based and investment loans as well as Analytical and Advisory Activities (AAAs). 77. As the Competitiveness AAA has shown, an efficient, solid and diversified financial system is essential to enhance Mexican competitiveness. The reforms supported in this DPL will create the environment necessary to channel more efficiently the local savings and investment base towards productive investments, thus complementing the reforms supported by the Competitiveness DPLparticularly with respect to improvements to the overall investment climate, for which access to finance i s an essential element. 78. The ongoing Savings and Rural Finance loans (Loans 7132-MX and 7240-MX) are supporting the G o M in strengthening the savings and credit cooperatives system. These loans support institutions that are compliant with the Popular Savings and Credit Law (a Law providing a regulatory framework for these type of smaller financial institutions) and that are financially viable and operationally effective. This seeks to improve them managerially, upgrade technology, and provide an enhanced level of outreach and access to financial services by the underserved Mexican population, particularly in rural areas. This loan is also continuing to strengthen Bansefi's capacity to provide technical assistance and continue fostering the development of savings and credit cooperatives. The overall strengthening of the financial sector that this proposed DPL supports would indirectly assist these efforts by creating a better environment in which commercial banks, Sofoles and other financial institutions could develop relationships with cooperative institutions, an increasingly common practice for financing and cash managementpurposes. 79. The ongoing RuralFinance Structural Adjustment Loan (Loan 7180-MX) supported the creation and strengthening of Financiera Rural, the government-owned non-bank financial institutiondeveloping rural financial markets and lending to rural and agricultural sectors. As Financiera Rural increases its emphasis on developing markets, and away from direct lending, it i s boundto benefitfrom the reforms to strengthen financial markets supported by this DPL. 80. The World Bank has supported the Mexican government's move to a market-based housing finance system in recent years. The recently completed FOVI RestructuringProject (Loan 4443-MX) supported the creation of SHF, which ultimately contributed to the development of the Sofoles market. A second series of projects i s supporting reforms to housing and land markets for the poor, including actions in housing policy and institutions, finance (credit and savings, subsidies), property rights, urban development and slum upgrading, land development and access by the poor, and disaster mitigation (particularly the Affordable Housing and Urban Development Development Policy Loan, HUDPL 11, Loan 7340-MX, and the Housing and Urban Technical Assistance Loan, Loan 7261-MX). Housing finance reforms supported by the HUDPL11, and the proposed HUDPL 111, concentrate on fostering the development of microfinance programs for housing The strengthening of the capital markets that this proposed DPL would support complements these loans, given the role that Sofoles, and their increasing access to capital markets, play in housing finance. The housing finance reforms to be supported by the second operation of these series will also complement the HUDPL series by addressing constraints in the housing finance infrastructure, particularly with regards to credit enhancement products to facilitate the operation of the private housing finance system. 31 81, The Innovation for Competitiveness Project (Loan 7296-MX) will strengthen the innovative capacity of the private sector. Among other elements, this Project supports a venture fund capital trust held by CONACYT (Cornisidn Nacional de Ciencia y Tecnologiu, the National Commission for Science and Technology) in Nafin. The reforms supported by this proposed DPL would facilitate the eventual listing in the capital markets of firms being funded through this mechanism (reforms included in the Securities Markets Law), a common mechanism in developed markets to graduate firms that havebeen successfully funded through venture capital. 82. The International Finance Corporation (IFC) has been particularly active in supporting housing finance activities through investments in the Sofoles sector. IFC also supports domestic capital markets through its involvement in local bond issuance, the provision of partial credit guarantees, associated technical advice, and direct financing in local currency. Direct financing totaled close to US$300M inFY04-06 (through September 2005). LESSONS LEARNED 83. The design of the proposed programmatic DPL takes into account the lessons learned from the overall program with Mexico and in general from Bank work with other middle- income countries. In particular, lessons learned were incorporated from the Brazil First Programmatic Loan for Sustainable and Equitable Growth (Ln. 7218-BR) and the Colombia First Business Productivity and Efficiency DPL (Ln. 7334-C0), which highlighted the benefits that arise from addressing financial sector issues in the context of overall economic competitiveness which in this case is reflected in the simultaneous preparation of the Competitiveness DPL. The most important lessons from these operations are the following: 84. The special value that country ownership and partnership have in middle income countries. Though country ownership i s essential for program success anywhere, this i s particularly important in a country such as Mexico, which has a sophisticated and effective group of policy makers and a good internal consultation process. The program supported by this operation has been designed by the GoM with the Bank bringing to bear its technical expertise in selected areas where it can add value beyond the GoM's already extensive capabilities. The proposed operation effectively responds to the Government's own priorities and commitment as reflected in the actions already taken as well as the fact that the policy thrust supported by this operation lies directly along key policy axes of the Government's National Development Plan. 85. The importance of flexibility to respond to changing circumstances. In order to implement a lending program that best addresses Mexico's needs as a creditworthy middle income country, the Bank needs the flexibility to be able to respond quickly to changing circumstances. This i s particularly important when supporting a Program, such as i s the case in this DPL series that spans across two presidential administrations. The programmatic approach, as opposed to a multi-tranche operation, provides the necessary flexibility to respond to new needs and priorities that can emerge duringthe implementationprocess while ensuring a long-term approach to a reformtheme. 86. The value of prior strong analytical work. In preparing financial sector policy-based operations, the Bank should contribute to enhance the government's program by bringing to bear strong technical capacity and ample cross-country experience. The Bank has maintained a very fruitful dialogue with the GoM over the last five years in the financial sector including an FSAPand investment and policy-based lending in housing finance, rural finance and public banking strengthening. 87. The need to promote financial sector growth policies in the context of improved prudential regulation. As the analytical work carried out as part of the Bank's support to the GoM's efforts after the last financial crisis (First and Second Bank Restructuring Facilities, Loans 7003-ME 32 and 7060-ME), financial sector growth i s unsustainable without continued improvements in the regulatory framework for supervision and regulation. 88. The need to take into account the politicaleconomy of reform during programdesign. Indesigninga policy-based operation, political factors andthe legislative needs of the country needto be understood and included in the dialogue with the country, particularly if part of the implementation of the reform program will involve a future administration. The consultation and legislative process that has been carried out by the GoM has facilitated reaching the consensus necessary to enact reforms in the financial sector policy areas supported by this proposed operation as the 2006 elections approach. Additional reforms in the area of financial infrastructure, particularly as relatedto creditor rights, are important but the Bank and the GoM agree that designinga program that would address these at this stage - beyond the reforms already carried out - would be risky and thus should be left as part of the dialogue with the new administration and be included as part of the policy notes being prepared by the Bank for discussion with the presidential candidates. ANALYTICAL UNDERPINNINGS 89. The preparation of this operation has benefited from four key analytical documents preparedby the Bank duringthe last 18months: (a) Competitiveness and Trade AAA. This provides a broad overview of the constraints to competitiveness faced by the Mexican economy including the role that lack of access to financial services plays. (b) Whither Latin American Capital Markets? This report, prepared by the Regional Chief Economist office, highlights the constraints being faced by capital markets in the region with particular emphasis on the Mexican case. (c) Mexico: Auditing and Accounting: Report on the Observance of Standards and Codes. This report reviews important aspects associated with the overall credit information environment and transparency associatedwith markets integrity. (d) Doing Business 2005 and Doing Business 2006. This World BanWIFC publication has followed the impact that financial sector reforms inMexico have had on the real sector. 90. The GoM and the Mexicanacademic community have also producedseveral analytical studies and other reports that were used in the preparationof this operation. In particular, the PRONAFIDE document and other BdM, CNBV and CONSAR documents have helped set the framework for the development of this program. Annex 7 lists the sources used. 91. The Bank, at the GoM's request, is currently undertakingadditional analytical work that will support the preparationof the secondproposedoperationof this series. This work will concentrate on three areas: (a) analysis of best practice alternatives for banking resolution mechanisms; (b) definition of adequate levels of regulatory latitude, as opposed to statutory definitions, for the private pensions sector; and (c) review of mechanisms to foster additional competition in the private pension administration market. 92. In addition to these studies, the GoM has requested the preparation of a Financial Sector Assessment Program (FSAP) Updateto take place during 2006. The original FSAP was done in 2002. 33 VI. THE PROPOSEDFINANCEAND GROWTH DPL OPERATIONDESCRIPTION 93. The development objectives of this operation is to support sustainable growth and the alleviation of poverty by: (a) contributing to reduce the probability of a systemic financial crisis; (b) fostering the sustainable growth of a financial system and capital markets that address the needs of the productive sector and increase overall competitiveness of the economy; and (c) diversifying the range of savings and investment instruments available to households. 94. Some degree of tension may exist between policies seeking to consolidate stability and those seeking to foster growth of the financial sector (Le., between the first and the other two development objectives mentioned above). The GoM has designed a policy program that minimize this tension by enacting prudential and disclosure reforms which are increasingly seen as international best practice essential to buildthe base on which to have sustainable financial growth. 95. The World Bank would support this policy reform process through a programmatic development policy operation in two phases, which would be executed over a period of 18 months. The programmatic series will focus on three policy areas through which the GoM seeks to attain the development objective presented above: (a) strengthening market integrity and prudential regulation; (b) increasing the depth, access and diversification of financing to foster a more effective role of the financial sector in the development of the economy; and (c) promoting diversified investment instruments to complement the aim of increased financial access through enhancednational savings levels and investment vehicles. 96. The second DPL would support the completion of implementation of the reform agenda inthe financial sector in these three areas. This operation would be prepared provided that the reforms supported by the first loan are sustained and that macroeconomic stability in Mexico continues to prevail. The GoM has defined this sequencing based on the availability of the analytical work supporting the design of some of the policy reforms as well as the political timing necessary for adequate consensus-building. The second loan is expected to be presented for Executive Board consideration inthe first quarter of FY08. 97. The GoM has completed all the previous actions for presentation of the first operation to the Executive Board, as listed in Box 1. Box 2 presents triggers for the preparation of the second operation. Actions underlined in these boxes are also being supported by the IADB's Financial System ConsolidationPolicy Loan. 34 StrengthenMarket Integrity and Prudential Regulation Enhance corporate governance and minority shareholder rights of firms participating inthe capital markets through the enactment of a new Securities MarketsLaw. publishedon December 30 2005, establishingthe role andduties of the management and boardsof listedcompanies, as well as applicable sanctions Strengthen prudential regulations and riskmanagement inthe banking sector throughthe issuancebv Comisidn Nacional Bancaria v de Valores (CNBV) of (a) Regulation(Dimosicidn)dated April 27 2005 definingstandards for external auditorsand credit institutionsin relationto the provisionof externalauditingservices: (b) Circulardated December 3 2004 defining capital adesuacy-basedearly warning indicatorsto trigger prompt correctiveactions; (c) Circular datedJuly 12004 establishingcorporategovernancerequirementsfor integrated risk managementof credit institutions; (d) Regulation(Disposicidn)datedJuly 5 2005 strengtheningcredit managementpracticesfor credit institutions; and (e) Circulardated August 20 2004 establishing risk-basedloanclassificationandprovisioningrules for credit institutions Enhance market disclosure and transparency through the issuance bv CNBV of: (a) Regulation(Disuosicidn) dated A ~ r i27 2005 establishingfinancial reportingreauirementsfor financialgroup holdingcompanies that are subject to l supervisionby CNBV: and (b) Regulation(Resolucidn) datedApril 27, 2005 that modifiesand harmonizesthe disclosure of financial information by creditinstitutions IncreaseDepth, Access, and Diversificationof Financing Enhance access to the capital markets through the enactmentof a new SecuritiesMarkets Law, publishedon December 30 2005 that (a) creates a new cornorate vehicle, SociedadAn6nima Promotora de Inversion, SAPI, to facilitate stock marketlisting; and (b) rationalizesminimumcapitalreauirementsfor securitiesbrokers to foster the entranceof new participants Increase the role of capital markets inthe supply of credit through the approval by the Legislatureof an amendment, publishedon November 30,2005, of articles 2 and 103 of the Law on Credit Institutionsallowing enterprisesto tap capital IPromoteDiversified marketsinorder to fund their credit activities InvestmentInstruments Enable better investment strategies and competition in the pensions industry through (a) Enactmentby the Legislature of an Amendmentto the Ley de 10s Sistemasde Ahorros para el Retiro datedJanuary 11, 2005 permittingthe transfer of assets to lower cost Afores without losingsenioritydiscounts; (b) issuance by Comision Nacionalde Sistemas de Ahorro parael Retiro (CONSAR)of amendmentsto Circular 15-12dated February 1, September 22 andOctober 27 2005 to make moreflexible the investment regimeof privatepensionsfunds and allow better alignment with workers' risk preferences; and (c) issuanceby CONSARof Circular 28-11(July 19,2005) and 22-10(August 1,2005) increasingcost transparency andlowering switchingtransactioncosts for contributors Increase the range of investment vehiclesin the capital markets throughthe: (a) issuanceby SHCP of ofcio 305- 35 Box 2: Indicative Triggers for SecondFinance and Growth DPL Strengthen Market Integrity and Prudential Regulation Create a transparent bank resolution mechanismthrough the submission to the Legislature o f legal reforms lMiscela'nea) creating a new banking resolution mechanism Enhance banking solvency rules through the issuance by SHCP of a set of resolutionthat: (a) aligns the regulatory capital requirements of development banks with those of commercial banks; (b) improves the quality o f regulatory capital by reducing the amount of deferred taxes that can be counted as capital; (c) eliminates distortions deriving from current market risk capital rules; and (d) defines lower regulatory capital requirements for insured mortgages Increase market transparency and integrity through the issuance by CNBV of circulars (a) requiring an ethics code for rating agencies; (b) preventing conflicts o f interest for financial analysts; and (c) through the issuanceby SHCP of an ethics code for public debt market makers IncreaseDepth, Access, and Diversification of Financing Enhance the financial infrastructure for private sector participation inhousing finance by (a) creating the legal framework for private sector provision o f mortgage default insurance (MI) and financial guarantees for mortgage-backed securities (MBS); and (b) amending the Organic Law of Sociedad Hipotecaria Federal (SHF) to improve SHF's corporate governance structure and enable it to segregate the capital that backs mortgage default insurance for lower- and middle- income families. Promote the development of infrastructure bonds and other private and public securities through the introduction of financial insurance for listed securities PromoteDiversified InvestmentInstruments Enable better investment strategies and competitions in the pensionsindustry through the finalization of studies on additional flexibility of SIEFORES investment regimes and disclosures of investment strategies and returns Increase the range of investment vehicles for more effective riskmanagement through the issuance by SHCP and CNBV o f a regulations expanding the framework to use derivatives to other intermediaries such as mutualfunds and insurance comuanies POLICY REFORMSSUPPORTEDBY THIS PROGRAMMATIC SERIES 98. The three policy areas supported by this operation cut across all the main financial sector intermediaries as shown in Figure 20. The following paragraphs describe in detail the reforms that the GoM i s carrying out in support of the objectives of this programmatic series for each one of these financial intermediaries. 36 Figure20: FinancialIntermediariesCoveredby the Policy Areas Supportedby this DPL .Strengthen prudentialregulationsand risk management .Enhance market disclosureand transparency of financialinstitutions *Create a transparentbank resoiution mechanism -Enhance the financial infrastructure for privatesector participation in housingfinance .Promote the developmentof infrastructurebonds and other private and pubiic securities *Enhance firms' accessto the capital .Increase the range of investment *Enhance corporate governance and markets vehicles in the capital markets minority shareholder rights *Facilitate the role of capital markets *Increase the range of investment in funding credit activities vehicles for more effective risk management .Enabie better investmentstrategies and competition in the pensions industry Banking Sector 99. With regards to the bankingsector, the first proposedDPL would support stronger risk management standards and prudential regulations to ensure sustainability of the renewed growth in the sector. This would be achieved via the issuance by CNBV of a regulation defining standards for external auditors and credit institutions in relation to the provision of external auditing service. This establishes clear rules for credit institutions in relation to the independence, rotation and CNBV reporting of their external auditors2'. Prudential regulations would also be strengthened through the issuanceby the CNBV of the following: (a) Circular defining rules on capital adequacy-based early warning indicators. The CNBV would classify banks into different categories depending on their capitalization level and would require prompt corrective actions if the capitalization index of any credit institution drops below 25 percent of the minimumthreshold (10 percent of risk-weighted assets); (b) Circular establishing corporate governance requirements for integrated risk management of credit institutions. This regulation defines the responsibilities of the Board of Directors and of senior management, and mandates the creation of a risk committee and periodic audit of the risk management process; *'For example, auditing firms would not be allowed to provide auditing services to banks for more than five consecutive years, and could only be re-appointedby the bank after an interruption of two years. 37 (c) Regulation establishing minimumrequirements and strengthening credit management practices for credit institutions. Institutions are required to develop credit manuals detailing their processes, methodology and procedures for credit origination and management; and (d) Circular establishing risk-based loan classification and provisioning rules for credit institutions. This norm introduces a more granular loan classification system that can be basedon banks' own internal models, and links it to specific provisioning rules. 100. The first proposed DPL would also support enhanced market disclosure and transparency. This would be achieved through the issuanceby CNBV of a: (a) Regulation establishing financial reporting requirementsfor financial group holding companies that are subject to supervision by CNBV. This norm enhances the transparency of non-listedfinancial holding companies by requiringthe public (electronic) dissemination of financial statements and other information; and (b) Regulation that modifies and harmonizes the disclosure of financial inforhation by credit institutions. Credit institutions are requiredunder this regulation to publicly disseminate, via their website, quarterly and annual financial statements, annual reports, as well as other information such as reports submitted to CNBV, loan classifications and board meetingresolutions. 101. In addition, the first operation would support increased competition incredit provision. This would be achieved through the submission to the Legislature of an amendment to articles 2 and 103 of the Law on Credit Institutions, allowing non-financial companies to tap capital markets to fund their credit activities. The aim of these amendments is to expand funding options for those non- financial companies that provide credit either as their main or ancillary activity (e.g. retailers and car dealers). 102. The submission to Congress of a new bank resolution2' law is expected to be included in the program for the second programmatic DPL. The current law provides for only two bank resolution methods: "financial strengthening"/"open-bank" resolution (whereby IPAB provides financial support to facilitate a problem bank's sale) and ``administrative bankruptcy" (whereby IPAB can effect the payment of guaranteed obligations and force subsequent liquidation or bankruptcy). While successful use of these methods has been made in the past, they tend to be time-consuming, costly and subject to legal disputes. The recent finalization of long-standing deposit insurance reform" originally introduced under the 1999 IPAB Law provides an additional impetus to consider other internationally accepted bank resolution arrangements. The draft law would introduce new and more efficient instruments such as "bridge bank" and "asset purchase-and-liability assumption", which would decrease the time and cost of bank resolutions. Conditions for the use of each instrument, as well as the process that would be followed in each case, would be outlined in the draft law and would depend on whether the institution i s systemically important. 103. The proposed second DPL operation would also seek to further enhance the existing banking solvency regime. This would be achieved through the issuance by SHCP of a set of regulations that: (a) aligns the regulatory capital requirements of development banks with those of 21 Resolution refers to the actions available to regulators to deal with a financial institution whose solvency has become impaired putting at risk its continued operation and, in the case of banks, their ability to cover their liabilities, particularly their deposits. 22As of January 1" 2005, the maximum deposit insurance coverage per natural or legal person has been reduced to 400 thousand UDIs (inflation-linked units of account), about US$125 thousand. 38 commercial banks; (b) improves the quality of regulatory capital by reducing the amount of deferred taxes that can be counted as capital; (c) eliminates distortions deriving from current market risk capital rules; and (d) establishes lower regulatory capital requirements for insured mortgages. These initiatives will also facilitate the eventual adoption of Base111in the Mexican banking sector, which has recently been tentatively set for 2007. Non-Bank Financial Institutions and Housing Finance 104. The proposed second DPL would support the strengthening of the housing finance infrastructure by fostering the credit enhancement market for housing finance and the role of SHF.The proposed amendments to the insurance law would permit Mexican and foreign insurers to offer mortgage default insurance (MI)and financial guarantees. To date, the Mexican government has been the sole provider of MI, most recently via SHF. As part of its efforts to develop the market, SHF i s actively working to attract private insurers to offer MI. The contract terms, financial terms, and claim requirements of SHF's new MI product are patterned on those commonly used in the United States. As SHF has built a portfolio of insurance in force, it has purchased reinsurance from two U.S. providers to mitigate its risk and to introduce US.providers to the Mexican market. The introduction of these amendments would allow the firms that have offered reinsurance to enter the market and offer a product directly to lenders. 105. The GoM has announced its intention to define an enhanced framework for credit enhancements in the mortgage sector and halve the capitalization requirements for residential mortgages that carry mortgage insurance. MIprotects the lender from a portion of the loss that it would face should the mortgage borrower default. A well-designed MI program promotes mortgage lending by mitigating a portion of lender credit risk, and increases mortgage affordability by reducing the down payment required to buy a house. Inwell-developed mortgage markets, such as Canada and the United States, MI offered by both the public and private sectors has played an important part in developing mortgage markets for moderate and low income households. The capital requirement for residential mortgages with MIwill fall from 8 percent to 4 percent once SHCP issues new regulations in the first half of 2006. Recognizingthe lower risk of insuredmortgages reduces the cost of banks to make such loans. Ina competitive system, these savings will be passed on to borrowers in the form of lower interest rates. 106. Financial guarantees serve as credit enhancements for investors in mortgage securities. A credit enhancement may take a number of forms, the simplest of which is a guarantee that the bond holders will receive full and timely payment of principal and interest, even when the underlying collateral pool fails to pay. For a fee, such an enhancement i s used to boost the rating of the senior bonds of an issuance to triple-A. Guarantees make mortgage backed securities (MBS) more attractive to investors, such as Afores, that have restrictions on the quality of bonds that they may purchase. SHF, private sector providers, and multi-laterals have offered credit enhancements for the dozen mortgage securities that have been issued to date in Mexico. The proposed amendments would define the guarantee product, how it may be offered, and how it i s to be regulated from a safety and soundness standpoint. 107. MI and guarantees would be offered only by specialized institutions subject to registrationand regulation by the finance ministry and the national insurance commission. The proposed regulatory changes establish minimum qualifications for the individuals that offer the insurance and manage companies that offer MI or financial guarantees. The proposed amendments broadly outline the terms by which capital requirements are to be calculated by the insurer, require the application of actuarial standards as approved by the national insurance commission, and require sanctions against insurers whose capital falls below that requiredby the commission. 39 108. The proposed amendments to SHF's organic law would enable it to better isolate the risk capital required for the MIbusiness and enhance its corporate governance structure. SHF management plans to establish legally separate subsidiaries for its lending and insurance businesses. The financial risks of SHF's products are distinct. In particular, the time horizon for MI i s much longer than that of the other products, and so would benefit from a separate pool of risk capital maintained in connection with the actuarial risk of the portfolio of insurance in force. The separation of these functions would not increase the staffing of SHF, but rather enable it to legally isolate the riskcapitalthat supports its separate lines of business. To make possible the segregationof capital for distinct business lines, the proposed amendments to SHF's organic law would permit SHF to hold ownership interests in subsidiaries that offer insurance for housing credits and that offer financial guarantees. 109. The changes to SHF's governance structure would better define the role of the audit committee of the board, alter the number and tenure of board members, and more precisely define prohibited conflicts of interest for independent board members. Audit committee requirements are spelled out in more detail, including defining SHF's code of ethics, accounting, valuation and reporting policies, defining its internal control system, and reviewing the results of external audits. The number of board members would rise to nine, five from the government and four independent ones from the private sector, with staggered terms. The government members would include, as at present, the secretaries of SHCP, the sub-secretary of SHCP, the governor of the BdM, and a sub-governor of the BdM. The representative of the Secretary of Development would be replaced by the Commissioner of the National Housing Commission. The four independent directors would be required to have experience in finance, law, administration, or accounting. They would be prohibited from having financial or other links with people or firms doing business with SHF, or having any of a list of other links to SHF. The terms of independent board members are independent of the election cycle. The proposed amendments include a detailed definition of prohibited links and activities for independent board members. The director general of SHF and independent members of the boardare prohibited from participating in partisan political activities. 110. None of the planned changes to SHF's organic law will change the sunset provision for government support of its debt issuances. Debt issued up to 2009 benefits from the full backing of the Federal government. After that, SHF expects to terminate its credit line to Sofoles, which will have to either fund their mortgage portfolios from the capital market, or become more like mortgage brokers, that do not hold mortgages inportfolio. To support this transition, larger independent sofoles, such as Su Casita, have issued MBS and mortgage bonds. Some Sofoles have been acquired by commercial banks and so are now funded with commercial bank deposits. To support smaller independent Sofoles, some market participants are exploring the idea of startinga mortgage conduit, a company that would assemble portfolios from smaller Sofoles into securities. CapitalMarkets Strengthening equity markets and risk capital 111. The centerpiece of the government's strategy to invigorate equity markets and risk capital is the new Securities Market Law recently approved by Congress, and to be supported through the first proposed DPL. The bill aims to improve corporate governance and transparency among listed companies, as well as making supervisory functions stronger, clearer and more agile. The roles of the board, general manager, auditors, advisory committees and majority shareholders would be clearly established and, in some cases, revised. The range of securities-related crimes and misdemeanors, and the penalties applicable will be expanded and specified more clearly, with "fraudulent administration" made a crime. The respective responsibilities of SHCP and CNBV are more clearly delineated. The bill also establishes a framework for supervision of securities 40 brokers (casus de bolsa) by the CNBV, which includes early corrective actions, the capacity to designate an intervening manager, and clear processes for license revocation, liquidation and initiation of bankruptcy procedures. This is going to bring Mexico more in line with international standards in corporate governance while tailoring it to local realities. The support that this bill has enjoyed among most business associations seems to indicate that the expected benefits in terms of attracting new investors outweighs the potential cost from increased compliance and disclosure requirements for listed companies. 112. The L a w also aims to promote competition and innovation among intermediaries by recognizing different types of securities brokerages, and varying requirements accordingly. This should also reduce the barriers for market entry, as operations licensed for a limited number or type of activities would have a reduced initial capital requirement, to be determined through CNBV regulations. 113. More importantly, the bill would create a new legal form for private enterprises, to facilitate private equity investment. The investment promotion limited company or Sociedud Andnima Promotoru de Inversion (SAPI), has enhanced protection of minority shareholders rights, in exception to the General Law of Corporations, to allow activities essential for private equity transactions, such as shareholders' voting agreements, tag-along and drag-along rights23,buyback mechanisms for the redemption of shares and restrictions to preemptive and exit rights. If a SAPIlists on the market, it would enjoy a three-year grace period to converge to normal public companies' standards. In the meantime, it is required to strengthen its corporate governance and information disclosure, and only qualified investors would be able to trade the shares. So far, a considerable proportion of risk capital in Mexico has been provided by U S investors, who not only provide equity funding to local SMEs, but also tend to have an active input in the strategic management of the selected firms. As such, an objective of the new bill is to make more Mexican SMEs an attractive investment target for foreign venture capital funds. The local institutional investors may start to play an increased role, but not in the short run, especially not the private pension funds who have only recently been allowed to take some equity risk through a conservative index-based structure. 114. Beyond the new Securities Law, the government aims to stimulate the risk capital sector by streamlining the role of public DBs in this area, measures that would be supported through the second proposed DPL. Although public development banks are active in the risk capital industry, with investments totaling around US$255 million, they have been hampered by a fragmented approach, differing investment policies and duplicatiQnof functions24. Inresponse, a working group was created in late 2004 under the guidance of SHCP with the participation of the development banks and BdM. Its mandate was to harmonize the risk capital investment criteria across these institutions. 115. Specifically, the working group is exploring the possibility of creating a single public sector vehicle (`fund of funds') for such investments, an initiative that would be supported by the second proposed DPL. It i s envisaged that the founding shareholders of such a vehicle will be the development banks themselves, while the `fund of funds' will only invest in risk capital funds that 23Tag along i s a contractual obligation used to protect minority shareholders, so that if a majority shareholder sells his stake, then the minority shareholders have the right to join the transaction at the same terms. Drag along enables a majority shareholder to force a minority shareholder to join in the sale of a company, but at the same price, terms and conditions, which i s useful in case a strategic investor wishes to aquires all the shares. These two types of shareholders'contractual agreements are frequently usedin riskcapital investment structures. 24Of that amount, US$lOS million represents paid-in equity investments (via funds and specialist venture capital vehicles called Sociedudes de Inversidn de Cupitules or "Sincas") mostly by Nafin and Bancomext, while another US$70 million represents direct lending primarily by FOCIR. 41 are active in Mexico25. The creation of such a vehicle would allow the concentration of expertise and resources in one area, as well as ensuring operational independence via the use of a professional administration company that would run it under a management contract. This should be completed with the next year. 116. Further government initiatives that would be supported by the second proposed DPL aim to strengthen market integrity. CNBV is working on a circular to establish a code of ethics for credit risk rating agencies and another to define conflicts of interest for financial analysts. These circulars would bring Mexico more in line with international standards on the subject, and should increase the confidence of investors and issuers in the opinions and recommendations of risk rating agencies and financial analysts. However, the efficacy of such codes depends on what provisions are made for their enforcement. Developing local debt markets 117. The GoM has recently focused its efforts on second generation reforms, which would increase the number of private issuers, and provide more liquid benchmarks for investors and private issuers. This i s needed to help channel more of the accumulated contractual savings into financing the productive sector and away from their current concentration on public debt. For example, the fast-growing private pension funds hold more than 80 percent of their assets in government debt, and while this i s already an improvement compared to earlier years, there appearsto be significant scope for further asset diversification (Figure 21 and Figure22). Figure 21: Evolution of Siefores' Assets Siefores' Financial Assets (Billion USD) ~ 50 40 30 20 10 n I .. 1997 1998 1999 2000 2001 2002 2003 2004 Governmental Securities 0 Non Governmental ~ Source: CONSAR 25 Existing investments by development institutions (Banobras, Bancomext, Nafin, FOCIR) will be transferred to the `fund of funds' by exchanging these for shares in it. The institutions can also voluntarily increase their participation by contributing new financing. I t is expected that new injections would come primarily from NAFIN. 42 Figure 22: Distribution of Siefore's Assets inEnd2000 and Mid 2005 December 2000 I Paraestatales 1.O% FinanceCies 0.7% I Non Government 7.4% I July 2005 Banks ~ Paraestatales Government 82% I Source: CONSAR and MexDer 118. Mexican authorities are promoting legal changes to prompt greater private debt ~~ issuance, for increased access to credit b y SMEs, households, and higher risk sectors such as infrastructure. Firstly, the Credit Institutions Law was amended to allow common law companies to issue debt on the capital markets, in order to finance their credit activities. Given that only large and creditworthy enterprises can tap the bond market directly, the objective is to eliminate the prohibition26such enterprises had on issuingdebt to provide supplier finance to smaller enterprises and consumers. The first proposed DPL supports this measure. Secondly, draft amendments to the Lnsurance and Warrant Companies Laws aim at promoting infrastructure bond origination, by introducing the Financial Insurance figure and opening it to foreign companies. Private and public infrastructure projects tend to require extensive credit enhancement mechanisms to qualify for investment grade, a pre-requisite to attract institutional investors. The second proposed DPL would support this measure. 119. The first proposed DPL supports the efforts underway to improve the regulatory and operational framework for secondary market liquidity tools, such as repurchase agreements and securities lending. These two instruments allow market makers and authorized institutional investors to finance their securities positions and cover short positions, thus enhancing the capacity of participants to provide more regular quotes to their counterparts, both for government and corporate 26So far, in their bond issuance prospectus, Mexican companies could not mention "customer credit activities" as a main reason for the bond issuance, or else they would be committing an intermediation crime (de`lito de intermediacidn). The legal change means that corporate bonds issued as part of the funding strategy of a company can be clearly identified as motivated by the credit activity of the issuer, even as bond repayment remains a general obligation of the firm. 43 securities. Proposed legal and regulatory changes would allow insurance companies to participate in these transactions, and to put in place the processesneededfor mutual funds, banks and Afores. 120. The Public Credit Directorate in SHCP (Crkdito Publico) is promoting several measures to improve the liquidity of benchmark Federal securities, and tailor them to investors' needs. Crkdito Pziblico has allowed for the possibility of stripping and reconstructing government securities, in preparation for potential demand from Siefores for zero-coupon bonds, as they start to invest as allowed by their new investment regime27. In order to promote liquidity, a 60 percent limit was introduced on the concentration of ownership of a single issue by a bank and a broker of the same group. These two measures would be supported by the first DPL. In parallel, Crkdito Pu'blico i s drafting an updated set of rules for quotation requirements, as well as a code of ethics for public debt Primary Dealers Cforrnadores de rnercados28)to push for enhanced activity and professionalism in their business practices. This would be supported by the second proposed DPL, and could have positive externalities for most investors in the Mexican capital markets, given the dominance of government debt among financial asset. Diversifying and strengthening derivatives markets 121. The regulators are taking several concrete steps to deepen the derivatives exchange - MexDer-, by allowing new classes of investors, and eliminating obstaclesto increased activity by existing ones. This is because liquidity is the main value-added of organized derivatives exchanges as compared with over-the-counter markets. MexDer i s playing an increasingly important role for risk management not only for domestic banks, corporates, and foreign investors, but also for domestic institutional investors. So far, the main users of the derivatives exchange had been brokers (for their own positions, but mostly on behalf of their corporate clients and foreign investors) and banks29. As market liquidity deepens, it becomes an attractive alternative for risk management of domestic institutional investors, who in turn add to that depth. Accordingly, CONSAR (CornisidnNacional de Sisterna de Ahorro para el Retiro, National Pension Savings Commission), SHCP, CNBV and CNSF (CornisidnNacional de Seguros y Fianzas, National Insurance Commission) are gradually opening up the possibility of usingderivatives, respectively to Afores, mutual funds and insurance companies. 122. CONSAR is well advanced in certifying individual Afores to use derivatives, while CNSF and CNBV are finalizing the applicable legal and regulatory framework, for insurance companies and mutual funds. This is expected to be approved during 200630 and would be supported through the second proposed DPL. The following step in this process would be for the regulator to certify individual institutions' compliance with the main dispositions of BdM circular 2019/95, detailing a list of 31 operational requirements to transact derivatives. Provided that these steps are accompanied with adequate supervision and disclosure of derivatives positions, they could have a positive impact on the performance of mutual funds and insurance companies. 123. In parallel, a series of recent and upcoming measures aims at increasing liquidity by stimulating the activity of existing participants on the MexDer. First, SHCP has supported the 27 The new Basic Fund2 can invest up to 15% incapital-protected notes that are best structured as a package of a '*Theseare zero coupon bond and an investment in the stock exchange index. chosen among banks and stock brokers, to act as the federal government's privileged partners in its domestic debt issuance and have exclusive access to the primary market, in return for obligations to participate actively in the primary and secondary market, and provide minimum liquidity to outstanding debt instruments. *'To manage their asset-liability risks, as well as to act as market makers to generate income by providing liquidity to the market through continuous quotations. 30 For insurance companies, legal amendments will allow the collateralization of assets for derivatives transactions. For mutual funds, CNBV circulars will regulate the management and disclosure of derivatives positions. 44 introduction of Global (or Omnibus) Accounts on the MexDer, i.e. generic and anonymous "clientele" accounts for intermediaries in the MexDer. It is expected that this will help increase market depth and liquidity, as well as cost-effectiveness. Second, SHCP recently submitted and Congress approved a legal change that exempts foreign investors in interest rate derivatives (involving inter-bank rate indexed or government bonds) from double taxation, when they are from countries where Mexico has taxation treaties. This will promote increased activity on the MexDer, as liquidity is a crucial ingredient to make the market an effective solution-provider for local investors' risk management strategy. These two measures would be supported by the first DPL, while the second proposed DPL would support CNBV draft of a banks' regulation to harmonize the valuation of OTC and MexDer derivatives, reduce the capital requirement for synthetic swaps created through futures (engrapados), and allow for increased flexibility in usingMexDer instruments as a hedge for OTC derivatives. This would increase the activity of banks, which are the main market makers on the MexDer. 124. The first proposed DPL supports authorities' efforts to further MexDer's initiatives to widen derivative products offering and respond to institutional investors' needs. In early 2004, SHCP approved MexDer's request to introduce options on the Mexican stock market index PC. Until then, the only available contracts were futures. Options purchase can answer different risk management needs, among investors and issuers, essentially to limit exposure to falling price. Options may play a significant role in Afores' penetration of the stock market through index- replication instruments, given the difficulty of trading on the cash market and complying with the requirement to replicate the index at all times, due to varying liquidity among individual stocks. More recently, MexDer introduced options and futures on some individual local stocks, domestic government bonds, as well as on exchange-traded funds (ETFs) on foreign stock indices, euro, gold and Brent crude oil. 125. The BdM is leading the drafting of a bill for a comprehensive Derivatives Markets Law, which would be supported by the second proposed DPL. The objective i s to strengthen and upgrade the legal framework for derivatives. Private Pensions System 126. The first proposed DPL would support the GoM's reforms to liberalize further the pension investment regime to allow a better alignment of worker's risk appetite with their pension funds'. In January 2005, CONSAR amended Circular 15-12 to establish that at least two funds should be offered by each Afore. Siefore Ba`sica 1 continues with the same investment regime as before, but allowing for investing abroad of up to 20 percent of funds. The other fund, Siefore Ba`sica 2, which could invest up to 15 percent in equity instruments and up to 20 percent abroad. Equity investment has to be through diversified instruments linked to indexes and with capital protection. All contributors under the age of 56 could choose between the two Siefores, and if they did not choose were assigned to Siefore Bdsica 2. Older workers have to be in Siefore Ba`sica I.The investment in capital protected variable income instruments can be done through structured notes, by investing in a fixed income instrument and an index or derivatives at the same time, or even buying the specific instruments that replicate the index. In this last case they have four days to buy all the necessary individual instruments and are allowed to have a permanent 1 percent deviation with respect to the index. 127. The goal of this change is that Siefores obtain higher returns for their contributors. In the case of Mexico this is important not only for pensioners but also for the fiscal position of the government, given the guarantees given to participants in this system. Expanding the set of instruments in which pension funds can be invested is crucial to obtain an adequate combination of 45 risk andreturn. Even ifthere are still important restrictionsit seems that there is a significant potential gain in diversification of risks under the new regulation. However, more flexibility in investment regimes has to go together with a close supervision of risks and information disclosure as safeguarding compulsory savings is crucial for the sustainability of the private pension system. CONSAR has been strengthening financial risk supervision by hiring trained personnel and restructuringthe Financial Vice-presidency to create a unit for risk analysis. 128. The GoM is also seeking to foster competition among Afores to increase the attractiveness of the system to workers and reduce administration costs. In January, 2005 an amendment to the Siefores Law (Ley de 10s Sistemas de Ahorro para el Retiro) was approved by the legislature. The main component of this amendment aims to enhance price competition by facilitating transfers if this reduces costs, and in general increase the system's accountability to contributors. Four key changes to the Law were made: (a) Elimination of the one-year minimum stay period so that a worker could switch before the year-end, to a cheaper Afore. (Article 74). This has had a significant impact on transfers and price dispersion has fallen notably. This change also had an impact on the entrance of new Afores, because on the one hand this eliminated an important barrier to entry and on the other hand new Afores only managed to enter this market with lower prices. (b) Increased flexibility in the requirements to qualify for discounts given to participants after being in the same Afore for a number of years. This was part of the price strategy of Afores to give incentives to participants to stay in the same Afore for a long time. The change in the Law now implies that instead of consideringthe number of years in the same Afore, they would have to consider the years in the system. As a result, commissions immediately dropped significantly to many contributors. (c) A third change was related to those workers incorporated into the system without choosing an Afore. These were previously assigned to one of the cheaper Afores and were free to switch afterwards. But, following this change, they cannot switch unless it is to a cheaper Afore, as for other account holders. (d) Establishment of fines for Afores in the case of fraud in the transfer process of contributors or if Afores charge participants more than they should. 129. Accountability is also being increased by enhancing cost transparency and reducing transaction costs associated with Afore switching. CONSAR issued Circular 22-10 in August 2005 to change the information forms sent to contributors. The new form simplified significantly the information provided to contributors and gives a comparison of the costs of each Afore, as well as information on returns in a more transparent manner. Inorder to facilitate switching from one Afore to another, so that commission reductions would be more effective in promoting competition, the CONSAR issued in July 2005 Circular 28-11, which allows switching through the internet. This has two major advantages; it reduces switching costs, enhancing competition, and operating costs are reduced. 130. Some of these reforms are already having the desired effects. The cumulative effect of these reforms has already increased transfers among different Afores (Figure23 and Figure 24) and i s lowering the average level and range of commissions. 46 Figure 23: Transfer of contributors between Afores 250000 200000 150000 100000 50000 0 1 ` AffiliatesSwitching 1 Source: CONSAR Figure 24: Annual equivalent fee (Percentage of Assets under Management) 3.80% 3.60% 3.40% 3.20% 3.00% 2.80% 2.60% 2.40% 2.20% 2.00% Note: The annual equivalent fee is the commission for an affiliate who has been in the Afore for five years, has a balanceof 22,000 pesos at the beginningof the year, and where the real rate of returnon the fund is 5 percent, with a bimonthly contribution of 721 pesos. Source: CONSAR 131. Regulatory changes have been implemented to make voluntary savings more attractive to Afores and participants. Mexico, like other countries in the region with similar programs, has identified a lack of interest among workers in their pensions, due partly to the relative complexity of pension investments, as a serious problem. This needs to be addressedbefore the population in the new systems gets closer to retirement (Le, when it would be arguably too late). Voluntary savings and employer-sponsored pension plans offered through the Afores would provide incentives to participants to become more involved with their pension decisions and contribute to legitimizing the 47 system. Circular 60-1 (August 2005) enabled workers not affiliated to the Mexican Social Security Institute (IMSS) to contribute to Afores. This is especially important for self employed workers who were not affiliated to IMSS. The incorporation of self-employed should increase coverage and competition in the system. (It is estimated that 11million workers are self-employed in Mexico.) The administrative procedures implemented for the self-employed also apply to civil servants who contribute to ISSSTE, the pay-as-you-go system for public sector employees. These workers could now contribute to Afores on a voluntary basis, subject to tax incentives. 132. Further liberalization of the investment regime would be supported by the second programmatic DPL. The Latin American Shadow Financial Regulatory Committee3', in Statement 13 (July 2005), mentions that foreign diversification i s desirable and important for pension funds, adding justification for measures taken to this end in Mexico. In any case, it must be borne in mind that the primary goal of pension funds is not the development of capital markets but the provision of adequate pensions, and the safety of compulsory savings i s crucial. CONSAR i s currently reviewing potential additional liberalization of the investment regime based on continued development of appropriate risk managementcapabilities among Siefores. 133. A completereview of the functioning of Procesar (the collectionagency)isbeing carried out to identify and implement improvements. This is not because fraud or diversion has been detected, but because of the lack of reliable identification numbers. As a result, in a significant number of cases an individual has more than one account, transfers between Afores take longer, and contributions are not allocated to accounts as soon as they should be. These improvements are expected to be includedin the second DPL. 134. Given the strong pricecompetitionthat hasbeenfostered by CONSARit is desirable to take measuresto enhance competitionfor returns as well. CONSAR has been actively working on the development and publication of investment policies, and the proposed second DPL operation would support this effort. For this purpose CONSAR is developing a structure for the elaboration and disclosure of investment policies that Siefores would impose themselves. CONSAR calls these policies a "benchmarking" scheme. This would add transparency to the investment decisions of Siefores and, it i s expected, better align incentives between Siefores and contributors. It i s likely that this would imply more competition between Afores in returns, increase differentiation, reduce conflicts of interest and promote longer term investment strategies. There would be no penalty or reward for Afores that deviate from the benchmark or underperform it. However, CONSAR would develop a performance index that would be disclosed to the public. LOANAMOUNT 135. The proposedUS$501.26 millionfirst programmaticDPL would bedisbursedinasingle tranche. It is expected that this tranche would be disbursed upon loan effectiveness in the third quarter of the Bank's 2006 Fiscal Year. VII. OPERATIONIMPLEMENTATION POVERTY AND SOCIAL IMPACTS 136. Prevention of financial crises is essential to poverty alleviation. In strengthening the financial system through greater market integrity and enhanced prudential regulation, the proposed program aims to reduce the risk of future financial crises, which can have a devastating impact on 31 The Committeeis composedof senior Latin Americanfinancial policy makers, includingpast ministers of finance and central bank presidents. 48 employment levels and poverty incidence. The 1994-1995 crisis caused a surge in poverty levels which took a decade to reverse. 137. The proposed operation does not support policies that combat poverty directly, but instead seeks to reduce it primarily through fostering faster and more sustainable economic growth. A strong, efficient and more diversified financial system and capital markets can provide private enterprises - the engine of economic expansion - with more resources, to invest and expand. Growth has historically been a powerful force for poverty reduction in Mexico and worldwide, by raising living standards, creating jobs and increasing the public resources available for social spending. 138. The program also includes measures that would promote more equitable growth, which has a greater poverty impact. Strengthening corporate governance and the rights of minority shareholders, and generally fostering greater and broader participation in the equity market should lead to a more equal sharing of the fruits of economic expansion. As discussed above, the ownership structure of Mexican companies has been extremely concentrated, which has contributed to the country's great income inequality. On the side of businesses,expanding access to the capital markets and other forms of financing, including risk capital, will benefit newer and smaller companies. Mexican poverty levels are highly sensitive to the pattern of economic growth - in terms of job creation and income distribution. Thus while in 1996-2000 the economy grew at 5.5 percent per annum, poverty fell slowly as unskilledwages dropped and income inequality increased. Conversely, while growth slowed between 2000 and 2002, extreme poverty fell considerably as rural incomes (including unskilledwages, remittances and transfers through Oportunidades3*) increased, and income inequality narrowed across the board. 139. Measures to fortify the system for housing finance, particularly at the lower-income end of the market, should help make home loans more readily available. Broadening access to mortgages enables more people to acquire their own homes, which provides them - in addition to the housing itself - with a means of accumulating wealth. In particular, the development of MIthat this DPL series would support is essential to allow the offering of higher loan-to-value mortgages, a mechanism that international experience has shown to be the best market-based instrument to provide home ownership to lower income households. 140. In promoting more transparent, efficient and competitive administration of pension funds, with access to a broader range of investments with potentially higher returns, the proposed program should strengthen these and make them more attractive as investments. This would contribute to providing more Mexicans with greater financial security in old age. The elderly are much more likely to be poor in Mexico, as elsewhere: in 1998, 38 percent of Mexicans aged 65 and over were poor, against 22 percent for the population in general33. However, Mexico's pension system continues to exclude most of the poor. The social security system covers only one in every five of the urban elderly population and only two percent of the total poor. 141. While the program can therefore be reasonably expected to contribute to reducing poverty in Mexico, the impacts would be extremely difficult to quantify. This i s because the drivers of economic growth and poverty reduction are multiple and intertwined. And many of them - including international economic conditions and commodity prices - are beyond the control of the GoM or the scope of this program. 32 Oportunidades i s the government's social programto alleviate extreme poverty. 33 Gill, Indermit S., Truman Packardand Juan Yermo (2004). Keepingthe Promise of Old Age IncomeSecurity inLatinAmerica: A Regional Study of Social Security Reforms.-Washington DC: TheWorldBank. 49 PUBLIC PARTICIPATION 142. The program supported by this DPL has benefited from four types of public participation mechanisms. These are: (i)the consultative process carried out as part of the preparation of the National Development Plan and of Pronafide; (ii)the public review of regulations mandated by COFEMER (Comisio'n Nacional de Mejora Regulatoria, National Commission for Regulatory Improvement); (iii)focus groups conducted under the preparation of the Mexico Competitiveness DPL; and (iv) the formal political consultation process associated with legal initiatives in Congress. 143. This DPL supports the implementationof the financial sector component of the National Development Plan 2001-2006. This Plan was developed by the GoM on the basis of several consultation mechanisms including 150,000 answers received to direct mailings and website postings on the three thematic areas covered by the Plan as well as 1,100 public meetings with broad geographic distribution. 144. All regulationsissuedby the GoM haveto be postedfor up to six months for comments in COFEMER's website. In particular, this requirement has covered all the regulations issued by SHCP, CNBV, and CONSAR that this DPL would support. Public agencies submitting proposed regulations to COFEMER must also include an impact assessment of the regulation identifying possible costs and affected stakeholders to facilitate COFEMER's dissemination efforts. 145. Focus groups were also used. As part of the preparation of the proposed Mexico Competitiveness DPL, the GoM with the support of the Bank organized ten focus groups with approximately 90 businesspersons from various sectors of the economic activity; directors of associations and chambers of commerce; and more than 30 officials from the federal, state and municipal governments. The Consejo Coordinador Empresarial, the major business umbrella organization in Mexico, was instrumental in coordinating the implementation of these focus groups. These groups addressed the need for continued financial sector development to enhance Mexico's competitiveness. 146. The current institutional and political arrangements in Mexico provide a solid discussion platformfor legal reforms. Congressional debates are open to the public and broadcast on television. The lack of clear majority of any party Congress further opens up the space for debate as no laws can be approved without a certain degree of consensus among more than one party. IMPLEMENTATION, MONITORINGAND EVALUATION 147. The SHCP will be the representative of the UnitedMexican States (the Borrower) and will be responsible for the overall implementation of this program in coordination primarily with the BdM, CNBV, and CONSAR. 148. Bank staff will monitor actions and review progress of the implementation of the proposed operation, as well as the subsequent actions of the Government's program through frequent visits to the country and constant communication with SHCP. Bank staff will focus on monitoring progress towards the indicative triggers for the second programmatic loan and the overall goals of the program. 149. MonitoringIndicators. Inaddition to the ProgramOutcomes presented inthe Policy Matrix, which will constitute the fundamental indicators against which the success of the program will be evaluated, several quantitative indicators will be monitored to ascertain the level of progress towards such outcomes, bearing in mind that many of these indicators are influenced by factors beyond the scope of the program. The baseline data for these indicators exist and SHCP and the relevant regulatory agencies have the capability to monitor them on a timely basis. 50 Table 8: Monitoring Indicators Development Objective Policy Action Area Indicators Enhancecorporategovernance and .CNBV reportson compliance minorityshareholderrightsof firms .Investor surveys participatinginthe capitalmarkets - World Bank DoingBusiness [nvestorProtection indicator Contributeto reduce the - Prudentialindicators of the probability of a systemic financial system (Capital financial crisis Strengthenprudentialregulationand risk management inthe banking sector adequacy, coverageratios) - Reports of fines to financial institutionson non-compliance Enhancemarket disclosure and - CNBV reports on compliance transparency - Total financingto the private Enhance access to the capitalmarkets IncreaseDepth,Access, and sector as percentageof GDP Diversificationof Financing Increasethe role of capitalmarkets inthe - New debt and equity issuances supply of credit - Total marketcapitalization - Number of Siefores - Average and dispersionof fees chargedby Siefores - Sieforesportfolio structureby Enablebetter investmentstrategies and asset class competitioninthe pensionsindustry - Sieforesportfolio yield - Number of participants in PromoteDiversifiedInvestment Siefores includingindependent Instruments workers - Liquidity of the domestic strips and rep0 markets Increasethe rangeof investment vehicles - Liquidity of secondary public in the capitalmarkets debt markets - Levelsof MexDer trading FIDUCIARY ASPECTS, DISBURSEMENTAND A U D I T I N G 150. The Mexico Country Financial Accountability Assessment (CFAA) was completed in October 2003. The assessment focused on the federal public sector, which was considered to have generally sound financial management systems and institutions. Country Financial Management (FM) risk was rated moderate, and all individual risk factors were rated low or moderate. The results of the CFAA have a direct impact on this project, as funds will flow into Mexico's public FM systems. The Bank has recently supported government efforts to strengthen some of the areas considered by the CFAA to be opportunities for improvement, such as the accounting processes and information systems. 151. The proposed Finance and Growth DPL will follow the Bank's disbursement procedures for development policy lending. The untied balance of payment support will be disbursed against satisfactory implementationof the development policy lending program and not tied to any specific purchases. The U.S. dollar loan would be made to the United Mexican States. The loan would cover the first of the two operations under the program. 152. Flow of funds (including foreign exchange) are subject to normal FMprocesses. It i s not possible to track the ultimate use of the foreign exchange provided by the Finance and Growth DPL 51 proceeds, but loan proceeds flow into a dedicated account34and from it to Mexico's budget, and are thus subject to normal public FM processes. By way of a letter, the Government will provide confirmation to the Bank when the loan amount has been credited to an account used to finance budgeted expenditures (as soon as step 3 in the following flowchart i s concluded). The account in which the loan proceeds will be deposited are to be temporarly held by the Borrower in NAFIN,then, on the same day of the deposit, NAFINwill transfer the funds to the Treasury's account in the Central Bank. The Bank's Financial Management (FM) team for Mexico carried out activities to provide reasonable assurance that loan proceeds flow into Mexico's normal public FM systems. Given the ample experience of Mexico managing Bank's DPLs, the FM team analyzed project's flow of funds, reviewed the audit report of BdM (the Central Bank) and the Country Financial Accountability Assessment report (CFAA). The IMF's report on the Safeguards Assessment of the Central Bank has not been conducted. Figure25 illustrates the flow of funds. Figure 25: Flow of Fundsfor Loan Proceeds - US$ US$ or MX$ MXS World Bank 1, NAFINI Secretariat of Finance 3 Central Bank National Treasury Budget Dedicated General Account in the Public Financial Account Central Bank Management Systems 153. The FM assessment concluded that from a fiduciary point of view, the control environment, procedures and regulations governing this Bank operation are generally adequate. Therefore, and basedon the flow of funds described above, the results of the work done by the FMteam and considering that the size of this DPL i s relatively small if compared with Mexico's overall public expenditures and foreign exchange reserves held by BdM, no additional FM-related arrangements are neededfor this project. 154. The Bank will not request a special audit of the dedicated account established in Banco de MCxico, as it i s already audited as part of the standard local regulation e.g. these type of accounts are audited by the internal control unit of BdM, the Supreme Audit Institution ASF and an external private firm, the latter as part of the annual audit review of the Financial Statements of the Central Bank. ENVIRONMENTALASPECTS 155. The reforms supported by the proposed Loan are not expected to have any significant adverse effects on the environment. However, increased economic activity derived from easier access to finance could potentially lead to negative environmental impacts. The GoM, with support through the Bank's Programmatic Environmental DPL Series, i s putting in place an effective environmental management framework associated with investments in key areas of the economy both at the federal as well as regional level. These efforts should mitigate the risks of any indirect environmentalimpact this Finance and Growth DPL may have. 156. This operation may benefit efforts to lower the destabilizing impact that natural disasters have. The Bank and other donors have been actively involved in providing technical advice 34This dedicated account in the central bank is a local standard procedure for DPLs (established by the GOM for control purposes), and it i s not an additional FM-related arrangement requested by the Bank. The FM team has accepted this procedure to-date, but as a result of the ongoing Country Systems work in Mexico, in the future funds might flow directly from the Bank to a general foreign currency account inthe central bank. 52 to the GoM on the use of financial instruments that can lower the fiscal impact of natural disasters. In particular, the GoM initiated with Bank support the technical studies necessaryto issue a Catastrophe Bond (Cat Bond) that would provide liquidity to the GoM in case of natural disaster and generally enhance its ability to spread and hedge financial risks. This activity is currently being funded by FIRST, a multi-donor financial sector trust fund. The reforms supported by this DPL seek to facilitate the operation of the capital markets and ultimately its increase in liquidity. This environment is essential for the GoM's ability to issue Cat Bonds once the technical work has been finalized. RISKS AND RISK MITIGATION 157. The two main risks faced by the proposedoperation are associated with the upcoming presidentialelections. Thepolitical turbulence risk is associated with the potential for disruption of some of the financial sector reforms supported by this operation if political events during the campaign or the presidential transition were to lead to macroeconomic instability. The transition risk refers to the possibility that the incoming administration reverses the actions already taken or fails to continue implementation of future reforms. 158. The last presidential transition showed that Mexican political institutions have been strengthened and the risk of politicalturbulence has diminished. The last presidential election broke the cycle of financial instability that had been associated with previous elections in Mexico. However, this risk is considered limited if some sort of political shock were to take place. The GoM i s seeking to mitigate this risk in the most effective manner possible, which i s to continue its prudent macroeconomic management and, with respect to the financial sector, continue strengthening its prudential regulation and supervision in part through the measures supported by this DPL. Furthermore, public debt management and the country's fiscal situation i s better than during the last two transitions. Additionally, the banking sector, the usual source of financial crises when political shocks have macroeconomic repercussions, i s better regulated, capitalized and dominated by foreign institutions with access to international capital. 159. The broad consensus across the politicalspectrum and the consultation process among stakeholders on the reforms supported by this DPL point to a limited transition risk. All the actions already taken that required legislative approval were approved with multi-party support - necessary in Mexico due to the lack of an absolute majority for any of the parties in the legislature. This indicates broad consensus on these elements of the financial sector agenda. For example, the Securities Markets Law was already approved in the upper chamber of Congress with votes from the three main political parties. In addition to the consultation process required for any law discussed in Congress, Mexican law requires all regulatory changes to be submitted to COFEMER for public dissemination and consultation before approval. This includes mandatory listing in COFEMER's website for comments for up to six months before a new regulation can be made effective. The Bank will contribute to additional mitigation of the transition risk through its dialogue with political candidates and the incoming administration. The Bank is starting the preparation of Policy Notes that will be discussed with presidential candidates during the campaign and with transition teams after the elections. These Notes will include a description of the key elements of the financial sector agenda incorporated in this DPL. 160. Additional risks exist associated with specific reforms supported by this operation and the GoM has sought to mitigate them through consultation processes. Inparticular, protecting minority shareholder rights and enhancing disclosure and transparency can be resisted on the basis that this could actually deter firms from seeking financing through capital markets. International experience shows that the benefits derived from increasing the number of potential investors and the potential that this has to reduce financing costs outweigh the costs associated with this type of reforms. To emphasize this, the GoM has carried out an extensive outreach campaign particularly 53 directedtoward firms that could be new entrants to the capital markets, as part of the discussion of the Law of Securities Market. A similar concern could exist regarding prudential regulation: that it could stunt financial sector growth. However, Mexican financial sector growth depends on continued public confidence in the sustainability of such growth and this type of reform will help build this. 161. Finally, changesin the macroeconomic environment would immediatelyaffect financial sector development but the GoM has mitigated this risk through a solid economicmanagement program. Even in the absence of political shocks or other events related to the political transition, the macroeconomic environment could be affected by other causes including external factors. Such an event would highlight the importance of the market integrity and prudential regulations supported by this DPL series as they seek to lower the probability of a systemic financial crises that such shock could generate. However, adverse macroeconomic conditions could also stunt or reverse the development of financial markets as appetite for new investments falls. The GoM has been carrying out solid macroeconomic management during the last decade to lower the possible impact of external shocks to the economy thus creating the conditions for the microeconomic-levelreforms supported by this DPL to bear fruit. 54 ANNEX 1:LETTER OF DEVELOPMENTPOLICY '2006. Aiio del Bicentenariodel natalicio del Benerneritode las Americas, Don Benito Juarez Garcia' SUBSECRETARIADE HACIENDA Y CRCDITO PUBLICO SECRETARIA DE 102-B- 003 HACIENDAY CREDIT0 PUBLICO Mexico, D.F., 26 de enero de 2006. Mr. Paul Wolfowitz Presidente Banco Mundial Washington, D.C.20433 Estados Unidos Estimado SeAor Wolfowitz: La presente Carta de Politica Sectorial describe la situacion economica de Mbxico y 10s esfuerzos en curso del Gobierno Federal a favor de una reforma integral del sistema financiero. Dichos esfuerzos estan dirigidos a consolidar un marco regulatorio mas solido que promueva la adecuada operacion del sector financiero y que asegure una sana actividad crediticia y un creciente acceso al capital. Asimismo, se ha venido aplicando una politica en materia de deuda publica cuyo objetivo principal es lograr satisfacer las necesidades de financiamiento del sector publico con el menor costo financiero posible, sujeto a un nivel de riesgo prudente en una perspectiva de mediano y largo plazo. Todas estas acciones son congruentes con 10s objetivos establecidos en el Programa Nacional de Financiamiento del Desarrollo (PRONAFIDE) 2002-2006. Los frutos de esta estrategia se han reflejado en la estabilidad que ha caracterizado la economia y en el sano desarrollo de 10s mercados financieros nacionales en 10s ultimos aiios, asi como en la confianza de 10sinversionistas sobre las perspectivasfuturas del pais. 1. El contexto macroeconomico Durante la decada de 10s noventa la estrategia de crecimiento economico de Mexico dependio de diversos acuerdos comerciales internacionales firmados en esos atios, 10s wales abrieron nuevas oportunidades de inversi6n y permitieron ampliar y diversificar la base exportadora del pais. Como resultado, el intercambiocomercial pas6 de representar el 27.3% del Product0 lnterno Bruto (PIB) en 1993 al 52.8% en el 2004. Sin embargo, la desaceleracion economics mundial que comenzo en el 2001 hizo evidente la necesidad de fortalecer e impulsar las fuentes internas del crecimiento. En este contexto, la administracion del Presidente Vicente Fox ha implementado una politica economica que tiene como objetivo promover la inversion y la demanda interna mientras se consolida el proceso de convergencia con nuestros principales socios 55 SUBSECRETARIA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 comerciales. Con este fin, el Gobierno Federal ha trabajado intensamente a traves de dos lineas de accion: i) la reduccion de 10s recursos financieros que absorbe el sector publico mediante una estricta disciplina fiscal que ha permitido reducir el deficit publico . presupuestario del 0.72% del PIB en el 2000 al 0.3% en el 2004 y ii) el aumento del ahorro financiero interno a traves de una ambiciosa reforma del sector financiero, que ha permitido que este indicador se incremente del 43% del PIB en el 2000 a 52% en el 2004. Paralelamente, el Gobierno Federal ha implementado diversas medidas para mejorar la competitividady promover la inversion privada, entre las que destacan las modificaciones al regimen impositivo de las empresas y las personas fisicas, la depreciacion acelerada de las inversiones, la promocion del sector vivienda, el apoyo a la competitividad comercial mediante mejoras en la logistica de la infraestructuraaduanal y el desarrollo de 10s mercados locales de deuda publica. Adicionalmente, se ha logrado que el credito bancario se convierta en un elemento sustentable para apoyar el crecimiento economico. En junio de 2005, por ejemplo, el credito vigente' a las empresas crecio a una tasa real anual de 20.6%, mientras que la cartera de credito vigente' para vivienda y consumo se expandieron a una tasa real anual de 45.1% y 44.4%, respectivamente. En conjunto, estas politicas han promovido una recuperacion balanceada del crecimiento economico. En el 2004, el consumo privado y la inversion crecieron al 5.5% y 7.5%, respectivamente, mientras que ias exportaciones se incrementaron 11.5%. Esta recuperacion no hubiera sido posible sin el compromiso con la disciplina fiscal, el manejo responsablede la deuda publica y una prudente politica monetaria. II. El PRONAFIDE El PRONAFIDE 2002-2006 establece 10s principales lineamientos y estrategias de la politica de hacienda publica necesarios para fortalecer las fuentes permanentes de financiamiento y, de esta forma, coadyuvar a lograr un mayor desarrollo. El programa pretende expandir la capacidad potencial de crecimiento del pais y, al mismo tiempo, garantizar un entorno estable a traves de una conduccion responsable de la politica economica. Su finalidad ultima es contribuir a la prosperidad economica general que ayude a reducir la pobreza, crear empleos y mejorar salarios dentro de un marco sustentable. 'Sin considerar programas de apoyo a deudores. 56 2 SUBSECRETARIA DE HACIENDA Y CRCDITO PUBLICO 102-B- 003 El pilar fundamental del Programa consiste en el impulso a la inversion a traves del aumento permanente de 10s recursos disponibles para su financiamiento. Ello requiere de un entorno legal y economico que promueva la canalizacion de 10s recursos ahorrados hacia 10s proyectos de inversion mas productivos y del fortalecimientodel ahorro phblico. La parte financiera del Programa es indispensable para lograr sus objetivos, pero no es suficiente, dado que tambien es necesario avanzar en la instrumentation de la agenda de reformas estructurales contenida en el PRONAFIDE. AI abrir nuevas oportunidades de inversion y establecer un entorno econornico que promueva una mayor inversion del sector privado en las actividades productivas del pais, las reformas estructurales acrecentaran la disponibilidad de recursos, propiciaran que estas se asignen con mayor eficiencia y resultaranen mayores y mejoresoportunidades de empleo. El Gobierno debe tener corno prioridad fundamental establecer 10s incentivos correctos para prornover una economia activa y en crecimiento. Lograr lo anterior, sin embargo, no es tarea facil. Requiere que 10s diversos grupos que conforman el complejo mosaic0 politico y social de nuestro pais concuerden en una plataforma economica basica que garantice la estabilidad macroeconornica y propicie la iniciativa individual en un entorno con regulacionesminimas. La experiencia internacional ha demostrado que 10s recursos que transitan a traves de un adecuado sistema financiero se canalizan de manera eficiente y expedita hacia 10s proyectos de inversion de mayor rentabilidad, y ha subrayado la importancia que tiene para el desarrollo el contar con un sistema financiero amplio que funcione bajo esquemas de regulacion y supervisi6n apropiados. Por ello, el PRONAFIDE ha promovido el establecimiento de un marco regulatorio y operativo que propicie la confianza de 10s usuarios del sistema financiero, disminuya 10s costos de transaccion, extienda la cobertura y estimule la eficiencia de la intermediacion. En este context0 el Gobierno ha impulsado una serie de iniciativas para prornover la cantidad y calidad del ahorro financiero y para fomentar el desarrollo integral de 10s mercadosfinancieros. 111. Reformas a1Sector Financier0 Gracias al trabajo coordinado entre las autoridades financieras y el H. Congreso de la Union se ha avanzado en la modernizacion del marco juridic0 del sector financiero. Durante la presente administration, el Congreso ha aprobado diversas iniciativas de reforma a la legislacionfinanciera. Ello,junto con las normasemitidas por la Secretaria de Hacienda y Credit0 Publico (SHCP), la Cornision Nacional Bancaria y de Valores (CNBV) y Banco de Mexico (BdM), se traduce en una reforma profunda y amplia de la actividad financiera en el pais. Seria demasiado dispendioso efectuar un analisis de cada una de 57 SUBSECRETAR~ADE HACIENDA Y CREDITO PUBLICO 102-8- 003 estas iniciativas por lo que nos referiremos tan solo a las medidas mas recientes y a aquellas que esperamos implementar en 10s proximos meses. 1. Marc0 Regulatorio de /as lnstituciones de Credito Prevencidn del Lavado de Dinero Y Financiamiento a1 Terrorismo Con relacion a la prevenciondel lavado de dinero y el financiamiento al terrorismo, entre junio de 2003 y mayo de 2004, Mexico participo en la Segunda Ronda de Evaluacion Mutua realizada por el Grupo de Accion Financiera sobre el Blanqueo de Capitales (GAFI). La evaluacion tuvo por objeto examinar el grado de apego de nuestro pais a las 40 recomendaciones emitidas por el referido GAFI, asi como a las 8 recomendaciones especiales en materia de financiamiento al terrorismo. En octubrede 2005, se atendio a la primera reunion plenaria del GAFI, en la cual fue presentado el Reporte de seguimiento o Follow-Up de Mexico respecto del cumplimiento de las Recomendaciones emitidas en la materia, del cual se origin0 una valoracion favorable sobre las actividades realizadas por nuestro pais en dicho tema. En cuanto a modificacionesa1marco regulatorio, fue aprobada, el 28 de enero de 2004, la Miscelanea relativa a Medidas contra el Lavado de Dinero y el Financiamiento a1 Terrorismo, la cual incluyodiversasdisposiciones que deben observar 10s distintos sujetos obligados para preveniry combatir estas actividades en nuestro pais e incorporandose en la legislacion mexicanalas mejores practicas internacionalesen la materia. Asimismo, en diciembre de 2005 fue publicada la reforma a la Ley de lnstituciones de Credito en lo relativo a 10s secretos bancario y fiduciario, con el objeto de hacer mas eficiente la obtencion de inforrnacion protegida por 10s mismos y curnplir con las recomendacionesemitidas por el GAFI. Por otro lado, se encuentra en analisis de la Camara de Diputados la modificacion a diversas leyes penales, previamenteaprobada por el Senado de la Republica, a efecto de tipificar diversos delitos relacionados con el terrorismo, cuyos aspectos mas relevantes son 10s siguientes: Se incorpora como delito el financiamiento a actividades u organizaciones terroristas. Se incluye la figura de terrorismo y financiamiento a organizaciones y actividadesterroristas internacionales. Se incrementa y ajusta la punibilidad del delito de terrorismo, tanto nacional como internacional. 58 SUBSECRETARiA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 0 Se tipifican como graves las conductas relacionadascon dichos ilicitos. Alertas Correctivas Tempranas Se reform6 y adiciono diversas disposiciones de la Ley de lnstituciones de Credito, a fin de introducir acciones correctivas tempranas, la cual permite fortalecer las rnedidas preventivasy correctivas para evitar oportunamente el deterioro de la situacion financiera de las instituciones de banca mGttiple, con el objeto de proteger al pGblico ahorrador, cuidar el comportamiento fluido del sistema de pagos y fortalecer la estabilidad del sistema bancario mexicano. Esta reforma obliga a la autoridad supervisora a actuar antes de que una institucion sufra un deterioro, reduciendo la discrecionalidad en la aplicacion de medidas correctivas y dando certeza juridica a las instituciones. Los principales casos a considerar son 10s siguientes: 0 Cuando la institucion cumple con un nivel de capital superior a1 lo%, las instituciones tienen la certeza juridica de que no se les aplicaran acciones correctivas tempranas. 0 Cuando la institucion registra un indice de capitalizacion entre el 8% (minimo requerido) y el lo%, solo se aplican rnedidas de caracter informativo y de prevencion, reconociendo que la institucion cumple con el minimo exigido por la regulacion. 0 Cuando el indice de capitalizacion de una institucion se ubica por debajo del 8%, se obliga a la Comision Nacional Banca y de Valores (CNBV) que imponga una serie de medidas correctivas, otorgandole a la institucion un plazo maximo de 12 meses para corregir su situacidn financiera y cumplir con el minimo que exige la reguiacion. Es importante mencionar que esta reforma, corresponden a medidas y etapas preventivas, otorgando una tregua cuando una institucion comienza a experimentar un detenoro. Resoluciones Bancarias En el cas0 del marco normativo del proceso de resolucion de instituciones bancarias, se esta por presenta a1 Poder Legislativo un proyecto de reforma a la Ley de lnstituciones de Credito y a la Ley para Regular las Agrupaciones Financieras que contempla diversos mecanismos que le permitan al lnstituto para la Proteccion al Ahorro Bancario (IPAB), la posibilidadde tomar decisiones oportunas respecto al cierre de una institucion de craito, 59 SUBSECRETARiADE HACIENDA Y CREDIT0 PUBLICO con base a la regla de menor costo, o bien, sanearla y venderla, respetando siempre el monto de depositos que se encuentren asegurados de acuerdo al regimen vigente, considerando las potenciales contingencias de caracter legal asociadas a este tip0 de procesos. Los principales puntosa considerar del esquema que se propone son: 0 Cuando el banco se ubique en una causal de revocacion (indice de capitalizacion menor al 8%) se le de la oportunidad de continuar operando. No obstante, se deberan afectar las acciones de la institucion en un fideicomiso de garantia y presentar el plan de restauracion de capital definido en la etapa acciones correctivastempranas. ' . 0 Cuando el nivelde capital sea inferior al4% o se incumpla de manera grave con el plan de restauracionde capital, se ejecutara automaticamente algun metodo de resolucion. En el cas0 de que la institucion no cumpla con la restauracion del capital en el plazo predeterminado o si el deterioro es grave, la reforma contempla definiciones de causales de revocacion. Es un esquema pacific0 porque la ejecucion del metodo de resolucion es de forma voluntaria y se respetan 10s derechos de propiedad de 10s accionistas. Lo anterior permitira reducir el riesgo de que se presenten impugnaciones en este proceso por parte de 10s accionistas, ya que desde la etapa inicial, las acciones de la institucion se encuentran en un fideicomiso de garantia. Asimismo, en una etapa posterior, se reformara la Ley de Concursos Mercantiles,con el objeto de incluir un capitulo especifico y detallado para el cas0 de concurso de una institucionde credito, reconociendolas particularidadesde la actividad bancaria. Sanciones Con el fin de actualizar el marco juridic0 aplicable a las sanciones que se imponen a las instituciones de credito, existe en el Congreso de la Union una reforma a la Ley de lnstituciones de Credito, que busca, por una parte, reducir la discrecionalidad de la autoridad, transparentando aun mas su quehacer, y por otra, proveer mayor certidumbre juridica al afectado. La reforma plantea, entre otras, las siguientes modificaciones: Crear un catalog0 de conductas especificas sancionables para todos 10s sujetos obligados por la Ley de instituciones de Credito. 60 SUBSECRETARiA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 0 Establecer rangos delimitadosde sancion pecuniaria para cada tipo de conducta. Redas para reaular /as inversiones que establecen la fraccion 111del Articulo 75 de la Ley . de lnsfifuciones de Credito Se emitieron disposiciones para regular las inversiones en empresas no financieras que establecen la fraccion Ill del Articulo 75 de la Ley de lnstituciones de Credito, con la finalidad de: Fomentar una mayor competencia en el sector crediticio y hacer llegar servicios financieros a segmentos de la poblacionque hoy no tienen acceso. Promover la apertura hacia nuevas opciones de negocios, buscando siempre consewar 10s principios de no arbitraje regulatorio y a su vez otorgar a las autoridades financieras capacidades de supervision indirecta sobre este tipo de empresas. Redas con Base en el Articulo 88 de la Lev de lnstituciones de Credito Se emitieron nuevas reglas con base en el articulo 88 de la Ley de lnstituciones de Credito, con el objetivo de abrir el esquema de regulacion para que las empresas de servicios complernentarios, no solo operen para el sistema bancario, sino tambien para otros sectores, aprovechando la infraestructuray especializacion de estas empresas. Requlacion aplicable a Sofoles que fenaan vinculos con alquna institucion de credito Debido a que recientemente se han celebrado adquisiciones de Sociedades Financieras de Objeto Limitado(Sofoles) por parte de algunas institucionesde credito, y que las reglas actuales son imprecisas respecto a la regulacion aplicable a entidades de este tipo que tengan vinculos patrimoniales con algun banco, se emitiran diversas disposiciones, con el objeto de presetvar 10s principios de no arbitraje regulatario y de independencia entre la Sofol e institucionbancaria, en cuanto a su interaccioncon 10s particulares, principalmente en las actividades que les son permitidas a ambos intermediarias (otorgamiento y manejo de.credito). Disposiciones en Maferia de Adrninistracion lnteqral de Riesgos Las nuevas disposiciones en materia de adrninistracion integral de riesgos para instituciones de credito sustituyeron a las reglas anteriormente enfocadas a banca de desarrollo y banca multiple. Estas disposiciones redefinen la taxonomia de riesgos, distinguiendo entre 10s riesgos discrecionales (de credito, mercado y liquidez) y 10s no discrecionales (operativo, tecnologico y legal) e incorporan la distincion entre limites y 61 SUBSECRETARIA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 niveles de tolerancia al riesgo. Asimismo, se sustituye la revision de 10s modelos de medicion de riesgos, antes a cargo de un experto independiente, por un informe tecnico interno mas completo. En materia de riesgo operativo, se establece la creacion de una base de datos sobre 10s eventos de perdida por dicho riesgo, por linea y unidad `de negocio, asegurando la recoleccion de informacion historica suficiente para avanzar en linea con 10s esfuerzos de capitalizacion de Basilea II. Por otro lado, se plantea un nuevo enfoque en materia de administracion de riesgo de mercado, limitando 10s modelos de Valor en Riesgo a las posiciones claramente vinculadas a la negociacion y valuaci6n de mercado; dejando el resto del balance sujeto a consideraciones en torno a 10s ingresos financieros esperados y el valor economico del capital. Adicionalmente, se definen con mayor precision las funciones del Consejo de Administracion, el Comite de Riesgos y la Unidadde Administracionde Riesgos. Calificacion de la Cartera Crediticia Con el fin de garantizar la aplicacion de sanas practicas bancarias, se emitio una nueva circular en materia de calificacion y provisionamiento de la cartera crediticia de las instituciones de credito (tanto para banca multiple como para la banca de desarrollo), la cual actualiza, homologa y compila, las distintas regulaciones emitidas al respecto. Esta regulacion considera cambios que permiten a las instituciones de credito ajustar la calificacion asignada a 10s financiamientos, tomando en cuenta todas las garantias que 10s respalden, ya Sean reales o personales; extiende la aplicacion de metodologias internas para la cartera crediticia de consumo, asimilando esta a las existentes para las carteras hipotecaria de vivienda y comercial; incluye nuevos mecanismos para calificar y provisionarcreditos concedidos a estados, municipios y sus organismos descentralizados, reconociendo de manera especifica el nivel de riesgo asignado por las agencias calificadoras y las particularidadesde las garantias de este tip0 de acreditados. Reauerimientos de CaDital de lnstituciones Bancarias Derivado de la innovacion y dinamismo del sistema financier0 tambien se reformaron las reglas para determinar 10s requerimientosde capital, ya que constituye uno de 10s pilares mas importantes de la regulacion y supervision financiera, por lo que su adecuada calibraciones de especial importancia. En este sentido, la reforma responde al dinamismo propio de las operaciones realizadas por las instituciones de credito, por lo que en cuanto a riesgo de mercado se refiere se determina una sene de mecanicas de valuacion de operaciones especificas, tales como instrumentos derivados que permitan reflejar de manera adecuada 10s riesgos que asumen las entidades financieras y se actualizan 10s coeficientes para determinar 10s requerimientos de capital por riesgos de mercado, bajo las condiciones de mercado 62 SUBSECRETARjA DE HACIENDAY CREDIT0 PUBLICO 102-B- 003 actuales, con el proposito de que estos reflejen la sensibilidad de las posiciones tomadas por 10sintermediariosante las actualesvariaciones en las tasas de interes en un horizonte de vencimiento mayor. Otro importante cambio fue adecuar, conforme a practicas internacionales, la deduccion de impuestos diferidos para que estos solo computen como parte del capital basico de las instituciones hasta el 10 por ciento. Asimismo se incorporaron principios de administracion de activos y pasivos, asi como el tratamiento de 10sseguros hipotecarios para determinar el valor de ponderaciona riesgo crediticio. Es importante seiialar que esta reforma permitira sentar las bases para la implernentacion del Nuevo Acuerdo de Capital conocido como Basilea II. Auditores Externos El desarrollo de 10s mercados financieros se sustenta en la confianza que depositan en ellos sus participantes, asi como en la transparencia en su operacion y en la inforrnacion que se hace disponible. Con este proposito, se ha revisado el marco de actuacion de 10s despachos de auditoria extema que prestan sus servicios a las instituciones bancarias, ya que constituyen un elemento adicional que resulta indispensable para reforzar la credibilidaddel publico en la inforrnacionque se genera. Destaca, asimismo, la incorporacion de lineamientosespecificos relativos a 10s requisitos de independencia que tanto el despacho de auditoria externa como el socio auditor deben cumplir, particularmente por lo que respecta a la prestacion de servicios adicionales a 10s de auditoria. Adicionalmente, se sustituyeron 10s informes que se requieren al socio auditor, con el proposito de que estos Sean de utilidad para la supervision de las entidades mencionadas. Control lnterno En materia de control interno, se mejoro y adecuo la regla vigente a estandares internacionales; asimismo, se incorporo a la banca de desarrollo al esquema hasta entonces limitado a la banca multiple. El proyecto reforzo las funciones de contraloria y auditoria intema y determina las responsabilidades,funciones y facultades entre el comite de auditoria, la aka direccion y el consejo de administracion. Por otra parte, requiere el desarrollo y perfeccionamiento de 10s sistemasde informacion. 63 SUBSECRETARiA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 Disposiciones de Caracter Prudencial en Materia de Credito. Las disposiciones de caracter prudencialen materia de credito actualizan la regulacion en materia del proceso crediticio, homologando la regulaciontanto de la banca multiple como de la de desarrollo. Asimismo, busca que las instituciones identifiquen, midan y limiten de manera oportuna, la toma de riesgos estableciendo a1efecto politicasy procedimientos de credito. Dichas disposiciones preven que, para alcanzar un adecuado desarrollo de la actividad crediticia, 10s organos sociales asi como el personal que participa en las distintas etapas del proceso crediticio, tengan claramente definidas sus facultades, funciones y responsabilidades. 2. Mercado de Valores El mercado de valores es uno de 10s sectores de la economia mas dinamicos a nivel mundial, sin embargo, en Mexico ese mercado no ha alcanzado aljn un nivel de desarrollo acorde con su potencial. Considerando el tamaiio de nuestra economia, todavia resulta bajo el numero de empresas cuyas acciones se encuentran listadas en la bolsa de valores, el valor de capitalizacion del mercado accionario, asi mmo la liquidez de las empresas. Ademas, se observa que America Latina atrae solo el 1% de 10s flujos de capital de riesgo en el mundo y que Mexico solo capta el 10% esos recursos. Con el objeto de tener el marco institucional adecuado para impulsar el mercado de valores se ha reformado su legislacion en varias ocasiones para incrementar la transparencia a sus participantes, reforzar la confianza de 10s inversionistas y profundizar 10s mecanismos que proporcionen una adecuada proteccion a 10s intereses patrimoniales del publico. Asi, con base en estos principios, sera posible continuar desarrollando la infraestmctura de ese mercado. Adicionalmente, se ha llevado a cab0 una serie de adecuaciones a las leyes fiscales para eliminar distorsiones que limiten el desarrollo de vehiculos de inversionen el mercado de valores. Ley de/Mercado de Valores La Ley del Mercado de Valores, en vigor desde 1975, ya habia comenzado a modernizarse a lo largo de sus multiples reformas y, de manera importante, con la reforma efectuada en junio de 2001, en la que se incorporaron: (i) el reconocimiento de mejoresderechos a favor de 10s accionistas minoritarios, (ii) la introduccion de un minimo de practicas de buen gobierno societario en las emisoras, (iii) 10s limites para la emision de acciones sin voto, (iv) las contrapartes centrales para mejorar la liquidez y (v) la sustitucion del regimende inscripcionde valores y aprobacionde su oferta pljblica basado en meritos, por un sistema que privilegia la revelacion de informacion. Uno de 10s 64 SUBSECRETARIA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 resultados exitosos de la reforma del 2001 fue la incorporaciondel Certificado Bursatil, un instrumento de deuda que ha resultado en una expansion importante del credit0 a las empresas. A pesar de 10s avances logrados con la reforma del 2001 prevalecio la necesidad de revisar integralmente la legislacionrelativa al mercado de valores y de homologar nuestra regulacion con 10s mejores estandares intemacionales, respetando en todo cas0 las caracteristicas que distinguen a nuestro sistema juridico. Por lo tanto se trabajo en una nueva Ley del Mercado de Valores. Esta nueva ley fue aprobada por el H. Congreso de la Union en diciembre de 2005 y comprende 10s siguientes objetivos: Promoverel acceso de las medianasempresas al mercado de valores, entendido este en su mas amplio sentido, para que de manera voluntaria, dichas empresas adopten buenas practicas de gobiemo societario y adecuados derechos a accionistas minoritarios. Consolidar el regimen aplicable a las sociedades anonimas bursatiles, cuyas acciones se encuentren listadas en la bolsa de valores, para adecuar su organizacion y funcionamiento mediante la modernizacionde sus estructuras societarias y su regimen de responsabilidades, haciendolosmas congruentescon la practica. Actualizar el marco~normativo aplicable a 10s intermediarios del mercado de valores ~- _ _ ~ ~~~~~~~~ ~~~ (las casas de bolsa) y el resto de las entidades financieras participantes de este sector, tales como bolsas de valores, instituciones para el deposit0 de valores, contrapartes centrales, empresas que administran sistemas para facilitar operaciones con valores, proveedoresde precios e institucionescalificadorasde valores. Modernizar el regimende delitos y sanciones. Redefinir las funciones y facultades de las autoridades financieras, con el animo de evitar duplicidad o redundancias en 10s procesos de autorizacion, regulaci6n y supervision de 10s participantesdel mercado. Fideicomisos de lnfraestructura v Bienes Rakes (FIBRAS) El impulso de las FIBRAS (Fideicomisode infraestructuray bienes raices) forma parte del esfuerzo de las autoridades por potenciar el desarrollo inmobiliario a traves del sector financiero. Los principales objetivos de las FIBRAS son: i) democratirar la inversion en bienes raices dando acceso masivo al mercado de bienes raices al publico inversionista, ii) destrabar las inversiones en bienes raices dandoles liquidez que tradicionalmente no poseen, iii) desarrollar el mercadode bienes raices y, iv) promover un nuevo tipo de activo ("assetclass")en el mercado de valores, con lo cual se diversifica el riesgo. 65 SUBSECRETARIA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 Las FIBRAS permitiran obtener financiamiento mediante la emision de Certificados de Participacion (CPs) en 10s mercados financieros publicos o en oferta privada. Los inversionistasen estos certificados participarande una parte alicuota de 10s bienes raices del fideicomiso. El valor de 10scertificadosestara directamente relacionado con el valor de 10s inmueblesy con 10singresosque generen. Las FIBRAS son fideicomisos, fiscalmente transparentes para efectos del impuesto sobre la renta (ISR) y del impuesto al activo (IMPAC), cuyo patrimonio esta constituido por bienes raices. El fideicomiso no paga impuestos ni hace retenciones, lo cual implica que se evita la doble tributacion y que 10s tenedores de 10s CPs tributan conforme a su regimen. El fideicomiso esta obligado a trasladar sus utilidades a 10s inversionistas, 10s cuales deberan acumular sus ingresos y pagar impuestos, segun su regimen fiscal (persona fisica, persona moral, residentes extranjeros, fondos de pensiones nacionales y extranjeros). El marco legal de las FIBRAS se encuentra contenido en 10s articulos 223 y 224 de la Ley del lmpuesto sobre la Renta introducidosen enero de 2004 y reformados en diciembre de 2005. Capital de Riesao El mercado de capital de riesgo le permite a las empresas acceder a fuentes de financiamiento para proyectos nuevos y para crecer en una etapa intermedia entre el credit0 bancario y el mercado de deuda y de capitales en la bolsa de valores. El financiamiento de capital de riesgo evita el apalancamiento que le resta flexibilidad a 10s proyectosde inversion. Ademas, la participacionen el riesgo promueve la transferencia de tecnologias y la institucionalizacionde las empresas. En varios paises el capital de riesgo ha sido una fuente fundamental para financiar nuevos proyectosy el crecimiento de empresas en diversas industrias, principalmenteen sectores de aka tecnologia. En 10s paisesdesarrollados, ha permitido la profundizaciondel sistema financier0 y ha logrado ser un apoyo importante al crecimiento economico. Con la introduccion de la S.A. Promotora de Inversion, se le permitira a las empresas no listadas en bolsa mandar una sefial a potenciales inversionistas que sus derechos seran respetados, aumentando la demanda de proyectos de inversion de capital de riesgo y privado. Por su parte, se ha trabajado legislativamente para lograr un vehiculo de inversion agil que intermedie la oferta y la demanda eficientemente y que tenga caracteristicas regulatorias y fiscales que lo hagan atractivo para 10s inversionistas. En diciembre de 66 SUBSECRETARiA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 2005 el H. Congreso de la Union aprobo la inclusion de 10s articulos 227 y 228 en la Ley del lmpuesto sobre la Renta, con lo que al vehiculo de inversion en capital de riesgo se le otorga la transparencia fiscal. Esto contribuye a que 10sfondos de inversion de capital de ' riesgo puedan establecerse en Mexico con costos mas competitivos y asi se impulsa de manera importanteestetipo de financiamiento para actividades productivas. 5. Mercado de deuda publica Durante la presente Administracion, el manejo de la deuda publica se ha consolidado no solo como un elemento fundamental para coadyuvar a la estabilidad macroeconornica y financiera sino tambien como un instrumento de promocion del desarrollo del sistema financier0 nacional. El objetivo principal de la politica de deuda publica ha sido captar 10s recursos necesarios para hacer frente a las obligaciones de deuda vigente y a las necesidades de financiamiento net0 en las condiciones de costo mas favorables posibles en el mediano y largo plazo, de acuerdo con un nivel de riesgo prudente. En general, la estrategia de gestion de pasivos de la presente Administracion ha seguido tres vertientes fundamentales: El deficit publico ha sido financiado en su totalidad medianteendeudamiento intemo. El financiamiento interno se ha realizado de forma ordenada, recayendo en la medida de lo posibleen la captacion neta de recursosa traves de emisiones de instrumentos a tasa nominalfija de largo plazo. El hecho de que el financiamiento neto se realice en el mercado local ha permitido que en el ambito externo se instrumente una politica proactiva para mejorar las condiciones de 10s pasivos publicos denominadosen moneda extranjera. Estas vertientes han resultado en una mezcla mas adecuada entre la deuda interna y la externa, disminuyendo la importancia relativa de 10s pasivos denominados en moneda extranjera dentro de 10s pasivos totales y, con ello, la vulnerabilidad de las finanzas pliblicas ante perturbacionesexternas y movimientos en el tipo de cambio. Paralelamente, se ha alcanzado una estructura de la deuda interna robusta y diversificada. De particular importancia ha sido el desarrolla del mercado local y la creacion de una cutva de rendimiento de largo plazo en moneda nacional a traves de la emision regular de instrumentos a tasa nominalfija con plazos de 3, 5, 7, 10, y 20 aiios. AI tercer trimestre del 2005, 10s titulos a tasa nominal fija con plazo mayor a un aiio representaron el 47.9% del saldo en circulacion de valores gubernamentales, lo que se compara favorablementecon el 14.5% registrado at cierre del aiio 2000. 67 SUBSECRETARjA DE HACIENDA Y CREDIT0 PUBLICO 102-B- 003 El desarrollo de un mercado local liquid0 y profundo ha permitidotambien que el Gobierno Federal avance en la tercera vertiente antes mencionada, al facilitar que las operaciones de credito extemo se dirijan a obtener 10s recursos para el refinanciamiento de 10s vencimientos en moneda extranjera en las condiciones de costo y plazo mas favorables posibles y no a captar recursos netos. En particular se ha instrumentado una politica proactiva de manejo de pasivos que ha mejorado el perf1 de vencimientos, ampliado la base de inversionistasy brindado mayor liquidezde 10s titulos mexicanos en el exterior. A la fecha, se ha cancelado practicamente en su totalidad la deuda asociada con el dificil proceso de reestructuracionde 10s ochenta, lo que ha evitado que existan vencimientos abultados de deuda publica y que se logren ahorros a valor presente en el costo financiero de la deuda publica. Evidentemente, 10s resultados alcanzados han tenido una gran trascendencia para el desarrollo economico en general y para el establecimiento de mercados financieros nacionales eficientes en particular. Asimismo, estos resultados han permitido sentar las bases para que el Gobiemo Federal lleve a cabo una gestion del credito publico compatiblecon las mejorespracticas internacionales. IV. Apoyo del Banco Mundial Nuestro compromiso con un decidido programa de reformas del sistema financiero queda plasmado en la anterior sinopsis. Consideramos que el apoyo del Banco Mundial ha sido, y seguira siendo, una valiosa herramientaen esta fase de reforma del sector financiero. El prestamo propuesto se inscribe en el marc0 del programa de respaldo a las reformas del sector financiero que el Banco Mundial ha venido desarrollando en 10s ultimos aiios, el cual incluye operaciones de asistencia tecnica y prestamos en apoyo de reformas especificas en dicho sector. Este programa ha permitido instaurar un dialogo provechoso con el Banco y contribuido al logro de avances significativos en la reforma del sector financiero. c- \ ,x. '. .,\. , \ 68 TRANSLATIONOF THE LETTEROFDEVELOPMENTPOLICY This Sectoral Policy letter describes the economic situation in Mexico and the Federal Government's current efforts to support an integrated financial system. These efforts are intended to consolidate a regulatory framework that promote adequate financial sector operations, assure healthy credit activity and improving access to capital. Moreover, the main objective o f the public debt policy has been to meet the financial needs of the public sector at least possible cost with prudent risk within a medium- to long-term time frame. These actions are in line with the objectives established in the National Financial Development Program (PRONAFIDE) for 2002-2006. The results of this strategy are reflected in the stability o f the economy and the healthy development of national financial markets during the last few years, as well as in investors' confidence in the future prospects of the country. 1. Macroeconomic Context During the 1990s, Mexico's economic strategy depended on a number of international commercial agreements, which created new investment opportunities and expanded and diversified the country's export base. As a result, international trade grew from 27.3 percent of GDP in 1993 to 52.82 percent in 2004. Nevertheless, the worldwide economic slowdown that began in 2001 made clear the need to strengthen and promote domestic sources of growth. Within this context, the Fox Administration has implemented an economic policy to promote investment and internal demand as it seeks to consolidate its close relationships with its main trading partners. To that end, the Federal Government has worked intensively along two lines of action: 1) implementation of strict fiscal discipline to reduce the public sector's demand for financial resources; this has reduced the public deficit o f 0.72 percent of GDP in 2000 to 0.3 percent in 2004; and 2) improvement of internal financial savings through an ambitious reform of the financial sector; this has resulted in an increase of this indicator from 43 percent of GDP to 52 percent. At the same time, the Federal Government has implemented a variety of measures to improve competitiveness and promote private investment. These measures include changes in the tax regime for companies and individuals, accelerated depreciation of investments, promotion of the housing sector, support of competitiveness through improvements in customs infrastructure and logistics and the development of local public debt markets. In addition, banking credit has been transformed into a sustainable element in support of economic growth. In June, 2005, for example, available credit for business grew at a real annual rate of 20.6 percent, while available credit for housing and consumption grew at real annual rates of 45.1 percent and 44.4 percent, re~pectively.~~ Together, these policies have led to a balanced recovery of economic growth. In 2004, private consumption and investment grew from 5.5 percent to 7.5 percent, respectively, as exports increased 11.5 percent. This recovery would not have been possible without the commitment to fiscal discipline, responsible management of the public debt and a prudent monetary policy. 35This does not includesupport for debtors. 69 2. PRONAFIDE PRONAFIDE 2002-2006 establishes the main financial policy guidelines and strategies necessary to strengthen permanent funding sources and thus to contribute to achieving greater development. The Program seeks to expand the country's potential growth capacity and, at the same time, guarantee a stable environment through the development of responsible economic policies. Its ultimate goal i s to contribute to general economic prosperity, which aids in poverty reduction, creates employment and improves wages within a sustainable framework. The Program's fundamental pillar i s to encourage investment through the permanent increase of available resources. This requires a legal and economic environment that promotes the channeling of savings to the most productive investment projects and the strengthening of savings by the public. The financial aspects of the Program are indispensable to achieving its objectives, but, not sufficient, given that it i s also necessary to go forward in the implementation of the structural reform agenda. B y creating new investment opportunities and establishing an economic environment that promotes increased private sector investment in productive activities, the structural reforms will increase the availability of resources, provide for their efficient use and result in more and better employment opportunities. The Government must have, as a fundamental priority, the establishment of the correct incentives to promote an active and growing economy. This i s not an easy task. It requires the diverse groups that make up the complex political and social mosaic of our country to agree on a basic economic platform that guarantees macroeconomic stability and provides a favorable environment for individual initiative with minimal regulation. International experience has demonstrated that an adequate financial system channels resources in an efficient and expeditious manner to the most profitable investment projects. It also underlines the importance of a financial system with broad outreach, based on appropriate regulation and supervision for development. To that end, PRONAFIDE has promoted the creation of an operational and regulatory framework that will encourage confidence among financial system users, reduce transaction costs, extend coverage and improve efficiency of financial intermediation. In this context, the Government has begun a series of initiatives to improve the quantity and quality of financial savings and encourage the integrated development of the financial markets. 3. Financial Sector Reforms a. Credit Institutions Regulatory Framework Modernization of the financial sector legal framework has advanced thanks to the coordinated work of the financial sector authorities and Congress. During the current administration, Congress has approved a number of reform initiatives in financial sector legislation. This, with the norms created by the Treasury and Public Credit Ministry (Secretaria de Hacienda y Crkdito Pu'blico, SHCP), the National Banking and Securities Commission (Cornision Nacional Bancaria y de Valores, CNBV) and the Bank of Mexico (Banco de Mkxico, BdM) has resulted in profound and wide reaching reform of the financial sector. It i s beyond the purposes of this letter to provide an analysis of each one of these initiatives, however, we describe the most recent measures and those that we hope to implement in the near future. 70 Prevention of Money Laundering and Financing of Terrorism Between June, 2003 and May 2004, Mexico participated in the Second Round of Mutual Evaluation of the Financial Action Task Force (FATF-GAFI). The evaluation's objective was to examine Mexico's adherence to the Task Force's 40 recommendations and the eight additional recommendations regarding terrorism financing. InOctober, 2005, Mexico attended the First Plenary Session of FATF-GAFI and presented its follow-up on compliance with the recommendations. The Session gave a favorable evaluation of Mexico's activities inthis area. Likewise, among other changes, the Miscellaneous Law on Money Laundering and Terrorism Financing (Misceldnea Relativa a Medidas Contra el Lavado de Dinero y Financiamiento de Terrorismo),approved January 28, 2004, included a variety of resolutions to be observed by interested parties to prevent and combat these activities and to incorporate international best practices inMexican law. Likewise, in December, 2005, the reform of the Credit Institutions Law on banking and fiduciary secrets was published. The goal of this reform of the confidentiality of bank and fiduciary information was to comply with the FATF-GAFI recommendations and make access to protected information more efficient. In addition, the House of Deputies is pursuing an analysis of changes to a number of laws, already approved by the Senate, to classify international terrorism crimes whose most important aspects are: 0 Financing of terrorist activities or organizations. 0 Inclusion of terrorism and financing of organizations and international terrorist activities. 0 Penalties for domestic and international terrorism are increased. 0 Classification as major crimes of these activities. EarlyCorrection Alerts The Credit Institutions Law (Ley de Znstituciones de Crkdito) was reformed to include early corrective activities, which strengthen preventive and corrective measures and avoid the deterioration of the finances of banking institutions. The reforms include protection of savings, the smooth operation of the payment system and strengthening the Mexican banking system's stability. This reform requires supervising authorities to act before an institution suffers a decline, reducing the discretion to apply corrective measures and providing legal certainty to institutions. The main cases to be considered are: 0 When the institution complies with an amount of capital greater than 10percent, it can be assured that no early corrective actions will be imposed. 0 When the institution registers a capitalization index between eight percent (minimum required) and 10 percent, only informational and prevention measures are applied, recognizing that the institution i s in compliance with the minimum capital adequacy requirements. 71 0 When the institution's capitalization index i s below eight percent, the National Banking and Securities Commission i s required to impose a series of corrective measures, giving the institution a maximum of 12 months to correct its financial situation and comply with the minimumrequirements. It i s important to mention that this reform includes preventative measures and stages to provide time when an institution begins to experience a decline. Banking Resolutions In terms of the normative framework for the resolution of banking institutions, a proposed reform will be presented to the Legislature to reform the Credit Institutions Law and the Financial Group Regulatory Law. This proposal contemplates various mechanisms that will permit the Institute for Bank Savings Protection (Znstituto para la Proteccion a1 Ahorro Bancario, IPAB) to effect decisions on the closing of a credit institution (based on the rule of least cost) or reform and sell it, with the goal o f assuring deposits based on the current legal regime andthe potential associated legal contingencies. The main points to be considered under this plan are: 0 When the bank i s under consideration for closure (capitalization index less than eight percent), it i s allowed to continue operating. Nevertheless, it must place its assets in a guarantee trust and present a capital recovery plan including the early corrective stages. 0 When capital falls below four percent, or the bank fails to comply with the capital restorationplan, a resolution i s automatically put inplace. Ifaninstitutiondoesnotcomplywithcapitaladequacyrequirementsintheagreedtimeorif the decline i s significant, the reform provides for the determination of grounds for closure. This is a non-controversialproposal becausethe resolution i s voluntary and the property rights of stockholders are respected. This will reduce the risk of stockholder takeover because the institution's assets have been placedin a guarantee trust. Likewise, the Commercial Proceedings Law (Ley de Concursos Mercantiles) i s expected to be reformed at a later date. This reform will include a specific and detailed section on proceedings for a credit institution, recognizing the particular needs of banking. Sanctions To update the applicable legal framework for sanctions imposed on credit and other non-bank intermediation institutions, a reform of the Credit Institutions Law will be presented to Congress. This law will seek to reduce the discretion of the authorities and provide greater legal certainty to the affected institutions. Investment rules based on Section IIIArticle 75 of the Credit InstitutionsLaw Section IIIof Article 75 of the Credit Institutions Law establishes rules for investment in non- financial institutions to: 0 Encourage greater competition in the credit sector and provide financial services to segments of the population that do not now have access. 0 Promote new business options, preserving the principles of non-regulatory arbitrage, and providing financial authorities the capacity to provide indirect supervision. 12 Credit InstitutionsLaw Article 88 Rules New rules based on Article 88 of the Credit Institutions Law will expand regulations to include businesses with complementary services in the banking system and other sectors, taking advantage of infrastructureand business specialization. Regulations applied to SOFOLs with links to a Credit Institution Because some credit institutions have acquired Limited Objective Finance Companies (Sociedad Financiera de Objeto Limitado, SOFOL) and the regulations are imprecise regarding theses types of institutions with ownership links to banks, new rules will be generated to preserve the principles of non-regulatory arbitrage and the independence o f the SOFOL and the banking institution with regard to their relationship with individual, principally in terms of the activities in which both types of institutions engage (lending and credit management). IntegratedRisk Management Rules The new rules on integrated risk management for credit institutions replaced those originally focused on development banks and universal banks. These rules redefine risk types, distinguishingbetween discretionary risk (credit, market, liquidity) and non-discretionary risk (operational, technological and legal), and incorporate these distinctions into limits and levels of risk tolerance. Likewise, the review of risk measurement models by an outside expert has been replaced by a more complete internal technical report. The new rules provide for the creation of a database of loss by risk, line and business unit, to assure the collection of enough historical information to continue with the capitalization efforts of Base1IT. Inaddition, a new focus on market risk management limits the Value-at-Risk models to positions clearly tied to market negotiation and valuation; it leaves the balance to considerations of expected income and capital value. Inaddition, the functions o f the Board of Directors, the Risk Committee and the RiskManagement Unit are defined with greater precision. Credit Portfolio Oualification To guarantee healthy bank practices, a new note on qualification and provisioning of the credit portfolio of credit institutions (universal and development banks), which up-dates, confirms and compiles the various regulations has been published. The regulation considers changes to permit credit institutions to adjust their assigned financing qualification, taking into account supporting guarantees, be they real or personal. Internal methodologies for the consumption credit portfolio have been expanded and now coincide with lending, housing and commercial methodologies. It includes new mechanisms to qualify and provide credit to states and municipalities and their decentralized organisms and to recognize more specifically the risk level assigned by the qualifying agencies and the specifics of the guarantees. Capital Requirements for Banking Institutions Rules to determine capital requirements were also reformed based on innovation and dynamism in the financial system. This constitutes one of the most important pillars of financial regulation and supervision and its adequate calibration i s of special importance. Inthis sense, the reformresponds to the very dynamism of the credit institutions' operations. This refers to a series of specific valuation mechanisms to determine the sensitiveness of the positions taken by the intermediaries in the face o f current variations of the interest rates in a 73 maturity horizon. For example, this includes derivatives that permit the adequate determination of capital requirements by marketrisksunder current market conditions. Another important change was to adapt the deduction of deferred taxes so that they are computed as part of the institutions' capital basis, up to 10 percent, in accordance with international practice. Likewise, the principals of assets and liabilities administration have been incorporated, such as the treatment of lending insurance to determine weights and credit risk. It i s important to note that these reforms represent the platform from which to implement the New Base1Capital Accord. External Auditors The development of financial markets i s based on the confidence of the participants and transparency in operations and available information. With this proposal, the framework to establish the offices for external audits that serve banking institutions has been reviewed. These constitute an additional indispensable element to improve public confidence in the information It should be stressed that, likewise, specific guidelines on autonomy, to avoid conflict of interest for the office and the individual auditor, have been included. This includes, in particular, the provision of additional services by the members of the audit team. The reports required of the audit associate were substituted by a proposal that these reports be of use for the institutions. Internal Controls In terms of internal controls, the rules were improved and adapted to current international standards and extends them to development banks. These rules had been limited to universal banks. The project strengthens the functions of the comptroller and internal audit and establishes the responsibilities, functions and authorities of the audit committee, the senior management and the board of directors. Inaddition, it requires development and improvement of information systems. Prudentialrules for credit The prudential credit rules up-date and standardize the regulation o f the credit process for universal and development banks. Similarly, institutions are expected to establish policies and procedures to identify, measure and limit risk, establishing, in effect, policies and procedures of credit. . These rules expect that, to reach an adequate development of credit activity, the organization and the personnel who participate in the credit process, have clearly defined responsibilities, functions and authorities. Securities Market The securities market i s one of the most dynamic sectors in the world. However, inMexico, it has not developed to its full potential. Considering the size o f our economy, the number of businesses with shares listed in the stock market i s low, as is the level o f market capitalization and businessliquidity. It i s notable that Latin America only captures 1percent of world capital risk flows andMexico only captures 10percent of those resources. To create an adequate institutional framework that encourages the growth of the stock market, legislation has been reformed at various times to improve transparency, strengthen investor 74 confidence and deepen the mechanisms that provide adequate protection to the public's interests. Based on these beginnings, it will be possible to continue developing the market's infrastructure. In addition, a series of adjustments of the fiscal law have been completed, and eliminate distortions that limit the development of investment vehicles inthe stock market. The Equities MarketLaw The Equities Market Law, in place since 1975, was modernized through a number of reforms and, importantly, with the reform of June, 2001. Included in this reform are: (i) recognition of minority shareholders' rights; (ii) introduction o f minimumgood governance practices of the issuingcompany; (iii)mits to the offering of non-voting shares; (iv) central counterparties to l i increase liquidity; (v) substitution of the systems of registration of shares and approval o f public offering based on merit with a system that prefers transparency of information. Despite the progress accomplished with the 2001 reform, it was necessary to conduct an integrated review of the stock market legislation, and to conform our legislation to that of the best international standards, within the particular confines of our own legal system. To that end, work has progressed on a new Stock Market Law. This new law was approved by the Congress inDecember, 2005 and contains the following provisions: 0 Promote access of mid-sized business to the stock market. This i s understood in its largest sense, so that these businesses will voluntarily adopt good governance practices and adequate minority stock holders rights. 0 Consolidate the rules for the publicly registered companies, whose shares are listed on the stock market, to adjust their organization and functioning based on the modernization of structure and responsibilities. 0 Update the applicable normative framework for stock market intermediaries (brokerage firms) and the other participating financial entities, such as stock exchanges, security depository institutions, central counterparties, companies that manage securities operations, price providers and securities rating companies. 0 Modernize crime and sanctions regulations 0 Redefine functions and capacities of the financial authorities, to avoid duplication and redundancy inthe process of authorization and supervision of the market participants. Trusts for infrastructureand real estate The work of the Trusts for Infrastructure and Real Estate (Fideicomiso de Znfraestructura y Bienes Raices-FIBRAS) i s part of the effort by authorities to strengthen the property development through the financial sector. The main objectives of the FIBRAS are: (i) democratize the real estate investment market by giving access to the market to the investing public; (ii) untie investment in real estate, giving them the liquidity they do not normally have; (iii) therealestatemarket;and(iv)promoteanewtypeofassetclassinthestock develop market, to diversify risk. The FIBRAS will permit financing through the issuing of Certificates of Participation (CPs) in the public financial markets or in private offerings. The investors in these certificates will participate in an aliquot part of the real estate o f the trust. The value of the certificates will be directly related to the value of the real estate and with the income they generate. 75 The FlBRAS are real estate trusts, fiscally transparent for income and assets. The trust does not pay taxes nor does it make deductions; this means that it avoids double taxation and that the owners of the CPs pay according to their individual situations. The trust i s required to transfer its profits to the investors, who accumulate earnings and pay taxes according to their fiscal identities (physical person, moral person, foreign resident, national pension fund, foreign pension fund). The legal framework of the FIBRAS i s found inArticles 223 and 224 of the Income Tax Law. These articles were introduced inJanuary, 2004 and revised in December, 2005. Capital Risk Market The capital risk market provides businesses with the financial resources for new projects and growth. The market i s an intermediate stage between bank credit and the debt and capital market of the stock exchange. The financing o f risk capital avoids the leveraging that eliminates flexibility for investment projects. In addition, participation in risk promotes technology transfer andthe formalization of businesses. In a number of countries, risk capital has been a fundamental source to finance new projects and for business growth in diverse industries-particularly in high tech industries. The developing countries, it has permitted the deepening of the financial system and has become an important support for economic growth. With the introduction of the "S.A. Promotora de Inversions" (SAPI), unlisted businesses can send a signal to potential investors that their rights will be respected, increasing the demand for private and risk capital investment projects. For its part, the Government has produced legislation to create a flexible investment vehicle that efficiently intermediates between supply and demand. In December, 2005, the Congress approved the inclusion of Articles 227 and 228 in the income tax law. These Articles provide for fiscal transparency in risk capital investment. This means that risk capital investment funds can be established in Mexico at competitive costs and thereby encourage this type of financing for productive activities. Public Debt Market Duringthe current Administration, management of public debt has been consolidatednot only as a basic element in macroeconomic and financial stability, but also as an instrument to promote development of the national financial system. The main objective of the public debt policy has been to capture the necessary resources to meet current obligations and financial needs under the most favorable conditions possible for the medium and long term with prudent risk levels. In general the present Administration's strategy to manage liabilities has follow three basic approaches: 0 The public deficit has been completely financed with internal debt. 0 Internal financing has been accomplished in an orderly manner through long term fixed rate instruments. 0 Net financing in the local market has created an external environment that permits a proactive policy to improve the conditions of public liabilities denominated in foreign currency. 76 These approaches have resulted in a more suitable mix of internal and external debt, reducing the relative importance of liabilities denominated in foreign currency and the vulnerability of public finances to external impacts and exchange rate changes. Similarly, the policies have resulted in a robust and diversified internal debt structure. The development o f a local market and the creation o f a long-term yield curve innational currency through regular issuance of nominal fixed rate instruments o f three, five, seven, ten and twenty years has been of particular importance. Presently, nominal fixed rate instruments with terms of more than one year represent more than 47 percent of government securities in circulation. This compares favorably with 14.5 percent at the end of 2000. The development of a deep local liquid market has also permitted the Government to advance on a third approach by facilitating external credit operations to obtain refinancing resources in foreign currency under favorable conditions of cost and terms and not capture net resources. At present, the debt associated with the difficult restructuring process of the 1980s has been almost entirely canceled. This has avoided the expiry of large amounts of public debt. It has also resulted in current-value savings of public debt. Evidently, these results have been significant for general economic development and for the establishment of efficient national financial markets in particular. In addition, these results have permitted the Federal Government to establish the basis for public credit management in line with the best international practices. 4. Support of the World Bank Our commitment to a decisive reform program of the financial system i s tied to this synopsis. We consider that the World Bank's support has been and will continue to be valuable tool in this reform phase. The proposed Loan fits within the framework of the support loans in the financial sector that the Bank has recently been developing. These include technical assistance operations, and loans that support reform in specific sectors. This program has resulted in a profitable dialogue with the Bank. It has also contributed to the achievement of significant advances infinancial sector reform The Under Secretary 77 . . . . . . . . 78 1 - 1 I I . 79 80 ANNEX 3: FUNDRELATIONSNOTE Public InformationNotice (PIN) No. 05/160 International Monetary Fund December 1,2005 700 19th Street, NW Washington, D.C. 2043 1USA IMFExecutiveBoard Concludes 2005 Article IV Consultationwith Mexico Public Information Notices (PZNs) form part of the IMF'sefforts to promote transparency of the I M F s views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issuedafter Executive Boarddiscussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in aparticular case. The staff report for the Article IV consultation with Mexico may be made available at a later stage if the authorities consent. OnNovember 9,2005, the Executive Boardof the International Monetary Fund(IMF) concludedthe Article IV consultation with Mexico36. Background The economic recovery that began in mid-2003 has continued, though at a slower pace in 2005. A broad-based expansion of economic activity in 2004, driven by a rebound of private consumption and private investment, took growth up to 4.4 percent. The economic recovery was accompanied by a boost to confidence, capacity utilization, and formal employment. Inthe first semester of 2005, growth slowed to 2.8 percent, reflecting several sector-specific developments, including a soft patch in US.industrial production. The most recent indicators point to a strengthening of activity in the third quarter of this year. After rising through November 2004, inflation has come down significantly in 2005, approaching the Bank of Mexico's 3 percent inflation target. The 12-month headline inflationrate peaked at 5.4 percent in November 2004, but has declined thereafter, to 3.1 percent in the first half of October 2005. Core inflation also has come down, to 3.2 percent. After tightening monetary policy since early 2004, the Bank of Mexico (BoM) signaled an end to its monetary tightening cycle in June 2005, and began to reverse that tightening in August. The firming of monetary conditions in this cycle was substantial-with the overnight interbank interest rate rising from less than 5 percent in early 2004 to 9 % percent by spring 2005. Since August, rates have come down to 9 percent, as the B o M has signaled 25 basis point cuts in the desired floor interest rate, in each of August, September, and October. From early 2004, the B o M has taken a number of steps to enhance its communication with markets, including signaling a desired minimumlevel of interest rates-yet maintaining the corto instrument (the borrowed reserves objective). The fiscal accounts improved in 2004 on the strength of rising oil revenues and restraint of current expenditures. The authorities achieved their target for the traditional deficit, 0.3 percent of GDP, and the 36Under Article I V of the IMFsArticles of Agreement, the IMFholds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary i s transmitted to the country's authorities. 81 broadly-defined deficit (the augmenteddeficit) narrowed to 2 percent of GDP, from 3.1 percent in 2003. Rising oil revenue helped finance an increase in capital expenditure, particularly in the oil sector. Gross public debt declined to 46.5 percent of GDP, in part through the write-off of some of the bank restructuringdebt. In2005, oil revenues are rising again, but their impact on the broader deficit is being more than offset by a deterioration in the non-oil fiscal balance. Staff project that the traditional deficit will narrow slightly, to 0.2 percent of GDP in 2005, while the augmenteddeficit widens to 2.3 percent of GDP. Oil income for the year is projected to be up by about % percentagepoint of GDP from 2004 (and about 1 percentage point over budget projections). It is expected that almost all of this unbudgeted revenue will go to compensate for shortfalls in non-oil revenue, and toward transfers for additional investment spending by PEMEX and the states, as implied by the budget law, with a small part going to the oil stabilization fund and reduction of the traditional budget deficit. The external current account deficit has remained modest, with a continued rise in oil exports and household remittances compensating for some widening of the non-oil trade deficit. With the recovery of economic activity in 2004 and 2005, imports of investment and especially consumer goods grew strongly, while weak auto exports to the US.,and enhancedcompetition from China and other countries, slowed non-oil exports. Mexican financial markets have recently performed strongly, as have other emerging markets. Sovereign bond spreads have continued to decline, recently to less than 150 basis points. At end-October, the stock market was up more than 75 percent (in domestic currency terms) since end-2003, with much of that gain coming since April of this year. The peso also has tended to strengthen this year though giving up some of its gains since August. The BoM has continued to abstain from market purchases of foreign exchange, but rising foreign exchange receipts from the state-owned oil company have pushed NIR upward. NIR reached US$61 billion by end 2004, about 4% months of Mexico's imports and 1.6 times its short-term external liabilities; at October 28, 2005, NIR was US$62.3 billion. The authorities have taken further steps to strengthen the public finances. The average maturity of the domestic debt of the federal government was extended to 3.1 years by June 2005, up from 2.6 years in early 2004. Exposure to currency depreciation has declined further as the public sector's annual foreign exchange earningsfrom oil now exceed US$30 billion, against interest payments on its foreign debt of US$9 billion. Furthermore, at mid-year the authorities announced that the federal government had accumulated enough foreign currency liquidity to allow it to forego any external bond issues through 2007. Executive Board Assessment Executive Directors commended the Mexican authorities for the improvements they had made in economic policies, institutions and structures over the last decade, which have contributed to greater macroeconomic stability and reduced financial vulnerability. Fiscal policy has earned broad credibility, with a track record of achieving the annual deficit targets, and a prudent monetary policy has established a low-inflation environment. A series of reforms has strengthened the financial sector and boosted its development. Directors welcomed that economic policy making i s taking place in a setting of greater inclusiveness and transparency in government. The challenge ahead will be to launch a new round of structural reforms that will enhance the economy's efficiency and competitiveness and ensure the transition to a more rapid growth path, while entrenching the considerable progress that has already been made in economic policy design and implementation. Concerning fiscal policy, Directors commended the authorities for achieving declining annual targets for the fiscal deficit, reducing the public debt ratio, and improving the debt structure, and they encouraged them to continue their efforts. At the same time, Directors noted that the overall fiscal balance has been benefiting increasingly from rising world oil prices, and that a reversal of oil prices could complicate fiscal policy if expenditures could not be reduced quickly. Most Directors urgedthe authorities to avoid a further widening of the non-oil fiscal deficit in2006. A few Directors recommended monitoringclosely the increase in spending by the state governments. Directors supported Mexico's intention to implement a medium-termbudget framework, with the objectives of reducing public debt further, strengthening the public finances, limiting vulnerability to oil revenue fluctuations, and allocating resources efficiently to essential investments, especially in the oil and social 82 sectors.Noting the important share of oil revenues in total government revenues, Directors also encouraged the authorities to take measures over the medium term to strengthen the tax system and broaden its base, including by bringing more of the economy into the formal sector. Directors considered that the current high oil prices make it more important than ever to ensure that the operations and investments of the state-owned oil company (PEMEX) are effective. Directors agreed that the monetary tightening of 2004 and early 2005 had been necessary to contain the rise in inflation and reverse inflation expectations. They were reassured that headline and core inflation are now close to the 3 percent target. With inflation expectations also moving down in recent months, the improved inflation outlook has allowed the Bank of Mexico to begin gradually loosening its policy stance. Directors recommended that the Bank continue to proceed cautiously inthis direction, noting that inflation expectations have not yet converged to the 3 percent inflation target. Directors welcomed the changes in the operational framework of monetary policy since early 2004. The Bank of Mexico's steps to refocus and sharpen its policy statements, provide an indication of its estimate of inflation for the current year, and shift toward defining policy changes through signalling a minimumlevel of interest rates have enhanced communication and the market's understanding of monetary policy objectives. Some Directors suggested that the authorities make public inflation forecasts for both the current year and a somewhat longer horizon, and adopt fully and explicitly an interest rate policy instrument. Directors considered that Mexico has beenwell served by its floating exchange rate regime. External competitiveness appearsto be broadly adequate at present, as reflected in the sustainable balance of payments position. Directors welcomed the considerable progress made in strengthening and reforming the financial sector and capital markets and reducing potential vulnerabilities, setting the stage for an environment conducive to economic growth. Commercial banks appear to be well capitalized, profitable, and provisioned against nonperforming loans. Directors were encouraged that bank credit has begun to expand after a long period of stagnation. They noted the efforts to further enhancefinancial sector supervision. Directors expresseddisappointment with the slow pace of structural reforms in recent years in spite of the authorities' commitment to move forward in this area. At the same time, they supported the authorities' emphasis on implementing small-scale reforms to improve structural competitiveness in specific sectors. Nevertheless, Directors emphasized that to confront Mexico's external competitiveness, productivity, and growth challenges effectively in the future, more thoroughgoing structural reforms will be indispensable, including in the energy and telecommunications sectors, the labor market, the judicial system, the tax system, and the regulatory and businessenvironment. Inthat light, Directors were encouraged that there i s a growing popular understanding of the need to implement an ambitious structural reform agenda. They advised the authorities to continue to stand ready to move aheadquickly to implement these reforms at the appropriate juncture. Mexico: Selected Economic and Financial Indicators 11 2000 2001 2002 2003 2004 (Annual percentage changes, unless otherwise indicated) National accountsand prices Real GDP 6.6 0.0 0.8 1.4 4.4 Real GDP per capita 21 5.1 -1.5 -0.7 0.0 2.9 Gross domestic investment (in percent of GDP) 23.7 20.9 20.6 20.6 21.7 Gross national savings (in percent of GDP) 20.5 18.0 18.6 19.2 20.7 Consumer price index (end period) 9.0 4.4 5.7 4.0 5.2 Externalsector 83 Exports, f.0.b. 3/ 21.5 -3.1 0.6 3.9 13.8 Imports, f.0.b. 41 23.1 -1.7 -1.3 1.9 15.8 External current account balance (in percent of GDP) -3.2 -2.8 -2.1 -1.3 -1.1 Change in net international reserves (end of period, billions 2.8 7.3 7.1 9.5 4.1 of U.S.dollars) Outstanding external debt (in percent of GDP) 28.3 26.1 25.2 25.9 23.5 Total debt service ratio 5/ 44.8 38.3 29.9 31.1 31.5 (in percent of exports of goods, services, and transfers) Nonfinancial public sector (inpercent of GDP) Augmented overall balance -3.7 -3.6 -3.4 -3.1 -2.0 Traditional overall balance -1.1 -0.7 -1.2 -0.6 -0.3 Gross augmented public sector debt 49.3 47.9 49.7 50.0 46.5 Net augmented public sector debt 42.2 41.7 43.6 44.0 41.2 Money and credit Monetary base 10.7 8.0 17.0 15.0 12.0 Broad money (M4a) 12.9 16.0 10.8 13.5 12.6 Treasury bill rate (28-day cetes, in percent, annual average) 15.3 11.2 7.1 6.2 6.8 Sources: National Institute of Statistics and Geography; Bank of Mexico; and Ministry of Finance and Public Credit; and IMFstaff estimates. 1/ Methodological differences meanthat the figures in this table may differ from those publishedby the authorities. 2/ Fundstaff estimates. 3/ Exports net of maquila sector imports. 4/ Excludes maquila sector imports. 5/ Public and private sectors. IMFEXTERNALRELATIONS DEPARTMENT Public Affairs: 202-623-7300 - Fax: 202-623-6278 Media Relations: 202-623-7100 - Fax: 202-623-6772 84 ANNEX 4: COUNTRY AT A GLANCE Mexico at a dance 1/17/06 Latin Upper- POVERTY and SOCIAL America middle- Mexico & Carib. income Jevelopmentdiamond` I 2004 Population, mid-year(millions) 1038 541 576 GNI per capita (Atlas method, US$) 6,790 3,600 4,770 Lifeexpectancy GNI (Atlas method, US$ billions) 704 9 1,948 2,748 T Average annualgrowth, 1998-04 I Population(%) 1 4 1.4 0.8 Labor force (A) 2 5 0.9 -0.9 GNI Gross per + primary Most recent estimate(latest year available, 1998-04) capita enrollment Poverty PA ofpopulation below nationalpovei?y line) 18 II Urbanpopulation(A of totalpopulation) 75 77 72 Life expectancy at birth (years) 74 71 69 1 L Infantmortality(per 1,000live births) 23 28 24 Child malnutrition(A of childrenunder5) 8 Access to improvedwater source Access to an improvedwater source (% ofpopulabon) 91 89 93 Literacy (% ofpopulation age f5t) 92 89 91 Gross primaryenrollment (% of school-agepopulation) 110 123 106 *-Mexico Male 111 126 108 Upper-middle-incomegroup Female 110 122 106 KEY ECONOMICRATIOS and LONG-TERMTRENDS 1984 1994 2003 2004 Economicratios` GDP (US$billions) 175 6 421 7 639.1 676.5 Gross capitalformationIGDP 19.9 21 9 20.6 21.3 Exportsof goods and ServicesIGDP 174 168 27.8 30.1 Trade Gross domestic savingsiGDP 27.7 17 1 19.0 199 - Gross nationalsavingsiGDP 22 7 149 19.3 20.8 Current account balancdGDP 2.4 -70 -1.3 -1.1 InterestpaymentslGDP 6.4 2 1 1.8 1.6 Domestic Capital Total debt/GDP 540 32 9 25.4 24.6 savings formation Total debt serviceiexports 45.1 25 7 17.6 150 Presentvalue of debVGDP Presentvalue of debtkxporls Indebtedness 1984-94 1994-04 2003 2004 2004-08 (average annualgrowth) GDP 2 7 3.3 1 4 4.4 3.0 Mexico GDP per capita 0 8 1.8 -0 1 2.9 1.6 Uooer-middle-incomenrouo Exportsof goods and services 6.0 9.6 2 7 11.5 3.6 STRUCTUREof the ECONOMY 1984 1994 2003 c (4 ofGDP) 2004 [Growthof capitaland GDP (%) Agriculture 9.4 6.0 3.9 Industry 34.9 26.8 25.8 Manufacturing 22.7 18.7 18.0 Services 55.7 67.2 70.3 Householdfinal consumptionexpenditure 63.1 71.4 68.6 Generalgov't final consumptionexpenditure 9.2 11.5 12.4 Importsof goods and sewices 9.6 21.6 29.5 1984-94 1994-04 2003 1 (average annualgrowth) 2004 Growthof exportsand imports("A) 1 Agriculture 0.8 1.9 3.5 4.0 T A Industry 3.3 3.3 -0.2 Manufacturing 3.5 3.6 -1.3 Services 2.7 3.3 1.9 4.6 :]+L Householdfinal consumption expenditure 3.6 3.7 2.3 5.5 Generalgov't final consumption expenditure 2.2 1.2 0.8 -1.2 10- Gross capital formation 5.6 4.8 -4.2 1.5 ---Exports +Imports Importsof goods and services 14.8 10.6 0.7 ~ ~~ Note 2004 data are preliminaryestimates * The diamonds show four key indicatorsin the country (in bold) compared with its income-groupaverage If data are missing, the diamond will be incomDlete 85 PRICESand GOVERNMENT FINANCE 1964 1994 2003 2004 Domesticprices I Inflation p/.) I ("' change) 20 Consumerprices 65.4 7.0 4.5 4.7 15 ImplicitGDP deflator 59.1 8 . 5 ~ 8.5 6.1 10 Governmentfinance "I 5 ("hof GDP,includescurrentgrants) Currentrevenue 31.2 22.7 23.2 23.2 99 00 01 02 03 Currentbudget balance -1.2 3.3 2.2 3.1 Overallsurplus/deficit -6.4 -0.3 -0.7 -0.3 -GDP deflator " O ' C P I TRADE 1984 1994 2003 2004 (US$miiiions) 1 Export and import levels(US$ mill.) Total exports (fob) 29,100 60,882 164,787 188,036 Oil 16,601 7,445 18,602 23,667 Agriculture 1,461 2,678 5,036 5,684 2w ow Manufactures 10,499 50,402 140,632 157,747 1500w Total imports(cif) 15,916 79,346 170,546 196,810 Food 100ow Fueland energy 50 000 I Capitalgoods 2,573 13,322 20,205 22,597 0 Exportprice index (2000=100j 114 90 105 112 98 99 00 01 02 03 W Importprice index (2000=100) 77 93 103 108 0 Exports E Imports Terms of trade 12000=100) 148 97 102 103 BALANCEof PAYMENTS 1984 1994 2003 2004 (US5 millions) Current account balanceto GDP (%) 1 Exports of goods and services 33,926 71,184 177,299 201,911 Importsof goods and services 21,028 91,616 187,680 215,372 Resource balance 12,898 -20,432 -10,380 -13,460 Net income -10,076 -13,012 -12,082 -10,938 Net currenttransfers 1,361 3,782 13,858 17,044 Currentaccount balance 4,183 -29,662 -8,604 -7,355 Financingitems (net) -2,034 12,463 18,437 11,416 Changesin net reserves -2,149 17,199 -9,833 -4,061 Memo: Reservesincludinggold (US5 millions) 7,355 6,300 59,027 64,204 Conversionrate (DEC, local/US$) 0.2 3.4 10.8 11.3 EXTERNAL DEBTand RESOURCEFLOWS 1984 1994 2003 2004 (US5 millions) 1 Composition of 2004 debt (US$ mill.) Total debt outstanding and disbursed 94,830 138,545 162,163 166,169 IBRD 2,852 13,038 10,717 9,567 IDA 0 0 0 0 G 9,900A 9,567 Total debt service 16,960 20,076 34,279 33,568 IBRD 485 1,989 1,972 2,499 IDA 0 0 0 0 Compositionof net resourceflows Officialgrants 27 47 Officialcreditors 832 -583 -372 -182 Privatecreditors 791 5,296 -418 1,578 Foreigndirect investment(net inflows) 390 10,973 12,625 17,377 Portfolioequity (net inflows) 0 4,084 F 137,392 World Bank program Commitments 576 2,380 888 621 A - IBRD E Bilateral Disbursements 682 942 1,258 767 B - IDA D Other multilateral - F Private -- Principalrepayments 253 1,065 1,359 1,976 C IMF - G -Short-term Net flows 430 -123 -101 -1,209 Interest payments 233 924 613 524 Net transfers 197 -1,046 -714 -1,733 Development Economics 1/I7/06 86 ~ a 6 6 6 8 % 8 8 x 8 8 X 6 1 % x 8 8 8 9 8 6 o o o o o m o o o o o o o o m o o o o o o o o N N N N N - N N N N N N N N - N N N N N N N N i - .-Pe 87 ANNEX 6: STATEMENT OFIFC'S HELDAND DISBURSEDPORTFOLIO As of I1/30/2005 (In US Dollars Millions) Held Disbursed PIApproval Company Loan Equity Quasi Partic Loan Equity Quasi Panic 1998 Ayvi 3.57 0 0 0 3.57 0 0 0 BBVA-Banaomer 16.04 0 0 16.04 (1 0 0 1995 Baring MexFnd 0 1.14 o0 o 0 1.14 0 0 1999 Baring MexFnd 0 1.41 0 0 0 I 4 1 0 0 1998 CIMA Puebla 3.25 n 0 0 3.25 0 0 0 2005 CMPDH 14.5 0 0 0 I0 0 0 0 2M16 Carlyle Mexico 0 20 0 0 0 8.08 0 0 Chiapas-Propalma 0 0.97 0 0 0 0.97 0 0 2001 Companamos I 0.66 0 0 I 066 0 0 2004 Compartamos 16.03 0 0 0 16.03 0 0 0 2002 Coppel 27.86 0 0 0 27.86 0 0 0 2005 Coppel 35 0 0 0 0 0 0 0 1999 Corsa 4.64 3 0 0 4.64 3 0 0 2005 Credito y Casa 21 86 0 0 0 0 0 0 0 2004 DTM 19.17 0 0 0 19.17 0 0 0 2001 Ecomex 4.25 0 0.25 0 2.25 0 0.25 0 2000 Educacion 5.41 0 0 0 3.81 0 0 0 2005 FlNEM 15.56 0.71 0 0 0 0 0 0 1997 Fondo Chiapas 0 3.14 0 0 0 0 0 0 1998 Forja Monterrey 4.64 3 0 4.64 4.64 3 n 4.64 2001 GFNorte 97.81 0 0 0 47.81 0 0 0 1996 GIBSA 8.11 0 0 27.29 8.1 I 0 n 27.29 1996 GIRSA 0 0 0.71 0 0 I1 0.71 0 2000 GIRSA 25.71 0 0 34.29 25.71 n 0 34.29 2005 GMAC Financiera 124.18 0 0 0 10.14 0 0 0 1998 Grupo Calidra 5.33 6 0 1.67 5.33 6 0 1.67 2004 Gmpo Calidra 23.41 0 0 0 22.67 0 n o 1989 Grupo FEMSA 0 0.02 0 0 0 0.02 0 0 I997 Grupo Minsa 4.77 0 0 7.16 4.77 0 0 7.16 1996 Gmpo Posadas 1.6 4.77 0 0 0 4.77 0 0 1999 Grupo Posadas 0 0 10 0 0 0 10 0 1998 Grupo Sanfandila 4.58 0 0 1.5 4.58 0 0 1.5 Grupo Su Casita 0 8 85 0 0 (1 8.85 0 0 2000 Innopack 0 15 0 0 0 15 0 0 Inreroyal 0 0.01 0 0 0 0.01 0 0 2003 Lorn de Real 50.05 0 20 101.25 48.76 0 20 101.25 1998 Menda111 25.44 0 0 54.76 25.44 0 0 54.76 2003 Mexmal 0 0 1.3 0 0 (1 1.3 0 1995 Mexplus Puenos 0 0.55 0 0 0 0.55 0 0 1999 Mexplus Puertos 0 0.25 0 0 0 0.25 0 0 1999 NEMAK 0 0 0.01 0 0 0 0 0 2003 Occidental Mex 26.4 0 0 35.2 26.4 0 0 35.2 Occihol 0 9.99 0 0 0 9.99 0 0 2003 POLOMEX S.A. 5.29 0 0 0 5.29 0 0 0 2000 Pan American 0 3.19 0 0 0 3.19 0 0 2002 PuenasFinas 9.75 0 0 0 9.75 0 0 0 2002 Qualita 0 0 3.5 0 0 n 3.5 0 2000 Rio Bravo 44.88 0 0 49.83 44.88 0 0 49.83 2004 SSA Mexico 45 0 0 0 45 0 0 0 2000 Saltilio S.A. 31.69 0 0 36.02 31.69 0 0 36.02 2000 Servicios 6.37 1.52 0 5 54 6.37 I 5 2 0 5.54 2W14 Su Casita 16.97 0 0 0 16.97 0 0 0 2005 Su Casita 52.15 0 0 0 0 0 0 1997 TMA 1.24 0 3.16 4.29 1.24 nn 3.16 4.29 2003 TMWC 3 0 0 0 0 0 0 0 2005 UNITEC 31.12 0 0 0 0 0 0 0 2003 Valle Hermoso 51.75 0 20 106.35 51.16 0 20 106.35 ZN Mexico I1 0 10 0 0 0 8.43 0 0 1998 ZN Mxc Eqty Fund 0 1.69 0 0 0 I.69 0 0 Total Portfolio: 889.38 95.87 58.93 469.79 554.33 78.53 58.92 469.79 Approvals PendingCommitment Loan Equity Quasi Partic 2001 Ecomex 3.5 0 0 0 2003 Mexmal 0 0 5 0 2003 Polomex 2 0 0 0 2005 Coppel I1 5 0 1 0 0 2Nl0 Educacion 3.2 0 0 0 2001 GFNorte-CL 0 0 0 100 2(KX Centro Espanol 5 0 0 0 2006 Mexico MBS CEF 3 0 0 0 0 XK15 Pan American 2 0 4.5 0 0 2005 Sanfandila(R) 0 0 0 6.49 1998 Cima Hermosillo 0 0 7 0 Total PendingComnutment: 48.7 4.5 22 106.49 88 ANNEX 7: ANALYTICAL SOURCES Aguilera, Nelly and CCsar Velisquez. Are there economies of scale in the pensionfind managers industry? A semiparametric approach. Mimeo. 2005 Barrientos, Laura. ContractEnforceability Indicators. Moody's Investors Service. New York, NY. 2002. BBVA Bancomer. Mexico - Sewicio de Estudios Economicos: Tercer Trimestre2005 Berstein, Solange and Chumacero R6mulo. Quantifying the Costs of Investment Limitsfor Chilean Pension Funds. Central Bank of Chile, Working PaperNo. 248. December 2003 CGAP. Mexico: Country-Level SavingsAssessment. July 2005. CNBV. Boletin Estadistico - Banca Multiple. Mexico City: CNBV. March 2005. de la Torre, August0 and Sergio Schmukler. Whither Latin American Capital Markets?Washington DC: World Bank. 2004. Fitch Ratings. Mexican Banks: 2004 Results. March 2005. Galindo, Arturo. Creditor Rights and the Credit Market: Where Do We Stand? Inter- American DevelopmentBank. Santiago, Chile. 2001. Gobierno de 10s Estados Unidos Mexicanos, Presidencia de la Repdblica. Plan Nacional de Desarrollo 2001-2006. Mexico. 2001. IIEFEquity Advisory Group. Corporate Governance in Mexico: An Investor Perspective. Instituteof InternationalFinance, Inc. 2003. IMF. Mexico - Financial System StabilityAssessment. WashingtonDC: IMF.October 2001 IMF.Mexico: 2004Article ZV Consultation. Washington DC: IMF. December 2004 Instituto Mexican0 para la Competitividad. Situacidn de la Competitividad de M&xico2004 Kappaz, Christina and John McNeece. Review and Action Planfor Development of the Venture Capital Industry in Mexico. NacionalFinanciera(SNC), May 2004. LaPorta, Rafael et al. Whichcountries give investors the best protection? Public Policy for the Private Sector Note No.19. Washington, DC: The World Bank. 1997. Latin American Shadow Financial Regulatory Committee. Statement No13: Putting Pension Funds to Work in Latin America: New Financial Instruments to Help Deepen Financial Markets. Washington DC. July 2005. Latinwatch. Sewicio de Estudios Economicos Tercer Trimestre 2005. BBVA Martinez Quezada, Renato and Enrique Flores Trillo. Modificaciones a la Legislacidn sobre Garantias en Mhico - Boletin a Clientes. Baker & McKenzie Mexico City. 2003 89 Martinez, Lorenza and Alejandro Werner. Capital Markets in Mexico: Recent Developments and Future Challenges. Mexico City: Banxico. 2002. Moody's Investors Service. Banking System Outlook: Mexico. February 2005. NAFW. Review andAction Planfor Development of the Venture Capital Industry in Mexico. US Trade Development Agency. 2003. Rofman, Rafael, Social Security Coverage in Latin America. Washington DC: Social Protection Discussion Paper Series, World Bank, May 2005. Secretaria de Hacienda y CrCdito Mblico. Programa Nacional de Financiamiento del Desarrollo 2002-2006.Mexico. 2002. World Bank. Doing Business in 2006 - Creating Jobs. Washington DC: World Bank. 2005 World Bank. Financial SectorAssessment: Mexico. (Based on the Joint IMF-World Bank FSAP), Washington DC: World Bank. October 2002. World Bank. Income Generation and Social Protectionfor the Poor. Mexico: World Bank. March 2004 World Bank. Mexico - Report on the Observance of Standards and Codes - Accounting and Auditing. Washington DC: World Bank. March 2004 World Bank. Poverty in Mexico: An Assessment of Conditions, Trends and Government Strategy. Mexico: World Bank. 2004 90 MAP SECTION To Los Angeles 115°W 110°W 105°W 100°W 95°W 90°W 85°W To Albuquerque To To Gila Bend Alamogordo Tijuana Mexicali UNITED STATES OF AMERICA Ensanada Sonoita San Ciudad Juárez To Felipe Midland Nogales BAJA G Agua Prieta MEXICO CALIFORNIA Rio Brav o RioGrande To 30°N 30°N ulf San Antonio of SONORA Yaqui C H I H U A H U A To Ojinaga San Antonio C Hermosillo To Guaymas Santa M Rosalia Conch os Sierra ado Sal BAJA a l i f o r n i a Sierra Houston Chihuahua Laredo Navojoa adre A CALIFORNIA Fuert C O A HMU I LFrontera SUR O e Loreto NUEVO Los Mochis adre LEON Gulf of Mexico 25°N 25°N ccidenta Matamoros Torreón Torreón Monterrey Saltíllo Saltíllo Culiacán Culiacán PACIFIC S I Nl O La Paz D U R A N G O TAMAULIPAS Durango OCEAN A L O A ZACATECAS riental Ciudad Victória Victória Mazatlán Mazatlán Cabo San Lucas Zacatecas SAN LUIS AGUASCALIENTES POTOSI Tampico QUERÉTARO QUERÉTARO San Luis This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information NAYARITLeAguascalientes Potosí Potosí YUCATAN Cancun shown on this map do not imply, on the part of The World Bank Tepic rma VERACRUZ Merida Group, any judgment on the legal status of any territory, or any GUANAJUATO Guanajuato HIDALGO endorsement or acceptance of such boundaries. 110°W Cozumel PuertoVallerta Guadalajara Querétaro Querétaro DISTRITO FEDERAL JALISCO Pachuca TLAXCALA Campeche MEXICO 20°N QUINTANA MEXICO MEXICO Morelia Jalapa CITY Bay of Campeche ROO Tlaxcala Veracruz Colima Toluca Chetumal Citlaltépetl (5,747 m) Citlaltépetl COLIMA Cuernavaca MICHOACAN Puebla CAMPECHE SELECTED CITIES AND TOWNS PUEBLA TABASCO Ba lsa s Villahermosa Gulf of STATE CAPITALS GUERRERO Chilpancingo BELIZE Honduras NATIONAL CAPITAL Oaxaca CHIAPAS Usumacinta RIVERS Acapulco S i e r r aM a d r e OAXACA Tuxtla Gutierrez MAIN ROADS d e l S u r Tehuantepec MORELOS Puerto NOVEMBER RAILROADS 0 100 200 300 Kilometers Escondido Gulf of GUATEMALA 15°N Tehuantepec HONDURAS IBRD STATE BOUNDARIES 15°N Tapachula To 0 50 100 150 200 Miles San Salvador EL 33447 2004 INTERNATIONAL BOUNDARIES 105°W 100°W 95°W SALVADOR