Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No: 51219-MX

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED

ECONOMIC POLICIES IN RESPONSE TO THE GLOBAL CRISIS DEVELOPMENT POLICY LOAN

IN THE AMOUNT OF US$1.504 BILLION

TO

THE UNITED MEXICAN STATES

OCTOBER 22, 2009

Poverty Reduction and Economic Management Department Colombia and Mexico Country Management Unit Latin America and the Caribbean Region

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

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CURRENCY EQUIVALENTS

(Exchange Rate Effective October 21, 2009)

Currency Unit = Mexican Peso MX$1.00 = US$0.0773

US$1 = MX$12.937

FISCAL YEAR January 1 – December 31

ABBREVIATIONS AND ACRONYMS

AAA Analytical and Advisory Services ALMP Active Labor Market Policies ANFEFE Acuerdo Nacional en Favor de la Economía Familiar y el Empleo

(National Agreement in Support of Households and Employment) BANCOMEXT Banco Nacional de Comercio Exterior (Foreign Trade Bank of

Mexico) BANOBRAS Banco Nacional de Obras (National Bank for Public Works) BANSEFI Banco del Ahorro Nacional y Servicios Financieros SNC (National

Bank of Savings and Financial Services SNC) CAFTA Central America Free Trade Agreement CAS Country Assistance Strategy CFAA Country Financial Accountability Assessment CFC Comisión Federal de Competencia (Federal Competition Commission) CNBV Comisión Nacional Bancaria y de Valores (National Banking and

Securities Commission) CONDUSEF Comisión Nacional para la Protección y Defensa de los Usuarios de

Servicios Financieros (National Commission for the Protection of Users of Financial Services)

CONEVAL Consejo Nacional de Evaluación (National Evaluation Board) CONSAR Comisión Nacional del Sistema de Ahorro para el Retiro (National

Commission of the Retirement Saving System) CPAR Country Procurement Assessment Review CPS Country Partnership Strategy CY Calendar Year DEC Development Economics DECDG Development Economics, Developments Data Group DFI'S Development Finance Institutions DG Director General (General Director) DPL Development Policy Loan EFTA The European Free Trade Association ENEU Encuesta Nacional de Empleo Urbano (National Survey of Urban

Employment) ENIGH Encuesta Nacional de Ingresos y Gastos en los Hogares (National

FOR OFFICIAL 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.

Survey of Income and Expenditures in the Households) ENOE Encuesta Nacional de Ocupación y Empleo (National Survey of

Occupation and Employment) FAO Food and Agriculture Organization FED Federal Reserve Bank FLC Flexible Credit Line FRL Fiscal Responsibility Law FSAP Financial Sector Assessment Program FY Fiscal Year GATT General Agreement of Tariffs and Trade GDP Gross Domestic Product HIPC Heavily Indebted Poor Countries HTS Harmonized Tariff System IBRD International Bank of Reconstruction and Development ICR Implementation Completion Report IDA International Development Association IDB Inter-American Development Bank IDE Impuesto a los Depósitos en Efectivo (Cash Deposit Tax) IETU Impuesto Empresarial a Tasa Unica (Business Flat Tax) IFC International Finance Corporation IMF International Monetary Fund IMMEX Programa para la Industria Manufacturera, Maquiladora y de

Servicios de Exportación (Program for the Manufacturing Industry, Assembly Plants and Export Services)

IMSS Instituto Mexicano del Seguro Social (Mexican Institute of Social Security)

INEG Instituto Nacional de Estadística y Geografía (National Institute of Statistics and Geography)

INFONAVIT Instituto Nacional de Fomento a la Vivienda de los Trabajadores (National Institute of Promotion of Housing for Workers)

ISSSTE Instituto de Seguridad Social al Servicio de los Trabajadores del Estado (Social Security Institute at the Service of the State Workers)

JCA Junta de Conciliación y Arbitraje (Board of Conciliation and Arbitration)

JSAN Joint Staff Assessment Note LAC Latin America and the Caribbean LAIA Latin America Integrated Association LCRCE Latin America and the Caribbean Chief Economist Unit LDP Letter of Development Policy LFT Federal Labor Law MDGs Millennium Development Goals MFN Most Favored Nations MIGA Multilateral Investment Guarantee Agency MOE Ministry of Education MOH Ministry of Health MOU Memorandum of Understanding

MP Mexican Pesos MTEF Medium-Term Expenditure Framework NAFIN Nacional Financiera NAFTA North America Free Trade Agreement NDP National Development Plan NIC's Newly Industrialized Countries NLTA Non-Lending Technical Assistance OECD Organization for Economic Co-operation and Development OTRI Overall Trade Restrictiveness Index PAE Programa de Apoyo al Empleo (Employment Support Program) PAETTSS Programa de Apoyo Emergente a los Trabajadores del Sector Servicios

(Emerging Support Program for the Workers in the Service Sector) PAL Programa Alimentario (Food Program) PEMEX Petróleos Mexicanos (Mexican Oil Company) PER Public Expenditure Review PET Programa de Empleo Temporal (Temporary Employment Program) PFE Employment Fostering Program PHRD Japan Policy and Human Resources Development Trust Fund PIB Producto Interno Bruto (Gross Domestic Product) PIDIREGAS Proyecto de Infraestructura Productiva de Largo Plazo con Impacto

Diferido en el Gasto (Program of Long-Term Productive Infrastructure with Differed Impact on the Expenditure)

PITEX Programa de Importación Temporal para Producir Artículos de Exportación (Temporary Import Program to Produce Export Goods)

PND Plan Nacional de Desarrollo (National Development Plan) PPE Employment Preservation Program PREM Poverty Reduction and Economic Management PROSEC's Programa de Promoción Sectorial (Program for Sectoral Promotion) PSBR Public Sector Borrowing Requirements PSIA Poverty and Social Impact Analysis RMBS Residential Mortgage Backed Security ROA Return on Assets ROE Return on Equity ROSC Report on the Observance of Standards and Codes SAAI Sistema Aduanero Automatizado Integral (Comprehensive Automated

Customs System) SAR Sistema de Ahorro para el Retiro (Retirement Saving System)

SAT Servicio de Administración Tributaria (Revenue Administration Service)

SCT Secretaría de Comunicaciones y Transportes (Ministry of Communications and Transport)

SDR Special Drawing Rights SE Secretaría de Economía (Ministry of Economy) SED Sistema de Evaluación de Desempeño (Performance Evaluation

System) SEDESOL Secretaría de Desarrollo Social (Ministry of Social Development)

SEMARNAT Secretaría de Medio Ambiente y Recursos Naturales (Ministry of Environment and Natural Resources)

SHCP Secretaría de Hacienda y Crédito Público (Ministry of Finance and Public Credit)

SHF Sociedad Hipotecaria Federal (Federal Mortgage Corporation) SME Small and Medium Enterprises SOFOL Sociedad Financiera de Objeto Limitado (Limited Purpose Financing

Society) SOFOM Sociedad Financiera de Objeto Múltiple (Multiple Purpose Financing

Society) STPS Secretaría del Trabajo y Previsión Social (Ministry of Labor) TA Technical Assistance TESOFE Tesorería de la Federación (Federal Treasury) TIGIE Tarifa de Importación y Exportación (Import and Export Tariff) TIIE Tasa de Interés Interbancaria de Equilibrio (Interbank rate) TPR Trade Policy Review TPRB Trade Policy Review Body TTRI Trade Restrictiveness Index UISA Unemployment Insurance and Savings Association UNDP United Nations Development Program USITC United States International Trade Commission VAT Value Added Tax WPS World Paper Study WTO World Trade Organization

Vice President: Pamela Cox Country Director: Gloria M. Grandolini

Sector Director: Marcelo Giugale Sector Manager:

Sector Leader: Rodrigo A. Chaves

David Rosenblatt Task Team Leader: Jozef Draaisma

Co-Task Team Leader: Esperanza Lasagabaster

MEXICO

ECONOMIC POLICIES IN RESPONSE TO THE GLOBAL CRISIS

DEVELOPMENT POLICY LOAN

TABLE OF CONTENTS

LOAN AND PROGRAM SUMMARY ................................................................................. i

I. INTRODUCTION ...................................................................................................... - 1 -

II. COUNTRY CONTEXT.............................................................................................. - 3 -

Recent Economic Developments in Mexico ............................................................... - 3 -

Macroeconomic Outlook and Debt Sustainability ...................................................... - 4 -

III. THE GOVERNMENT’S ECONOMIC POLICY PROGRAM AND PARTICIPATORY

PROCESSES....................................................................................................................... - 8 -

IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM ................................ - 13 -

Link to Country Partnership Strategy ....................................................................... - 13 -

Summary Update of the Implementation of the CPS ................................................ - 13 -

Collaboration with the IMF and other development partners ................................... - 14 -

Relationship to Other Bank Operations .................................................................... - 14 -

Lessons Learned ........................................................................................................ - 16 -

Analytical Underpinnings ......................................................................................... - 17 -

V. THE PROPOSED OPERATION .............................................................................. - 21 -

Operation Description ............................................................................................... - 21 -

Policy Area I: Fiscal Policy and Public Expenditure Management .......................... - 22 -

Policy Area II: Financial Access with Stability ........................................................ - 26 -

Policy Area III: Labor Market ................................................................................. - 29 -

Policy Area IV: Trade Integration for Growth and Integration ................................ - 32 -

VI. OPERATION IMPLEMENTATION ....................................................................... - 36 -

Poverty and Social Impacts ....................................................................................... - 36 -

Labor Market Policies .............................................................................................. - 38 -

Environmental Aspects ............................................................................................. - 39 -

Implementation, Monitoring and Evaluation ............................................................ - 39 -

Fiduciary Aspects ...................................................................................................... - 40 -

Disbursements and Auditing ..................................................................................... - 40 -

Risks and Risk Mitigation ......................................................................................... - 41 -

VII. ANNEXES ................................................................................................................ - 43 -

ANNEX 1. LETTER OF DEVELOPMENT POLICY ............................................ - 43 -

ANNEX 2. OPERATION POLICY MATRIX ........................................................ - 52 -

ANNEX 3. FUND RELATIONS NOTE ................................................................. - 56 -

ANNEX 4. MACROECONOMIC & DEBT SUSTAINABILITY ASSESSMENT- 58 -

ANNEX 5. ANALYSIS OF THE GOVERNMENT’S ECONOMIC POLICIES .. - 68 -

Annex 5a. Fiscal Policies and Public Expenditures .............................................. - 68 -

Annex 5b. Financial Sector Policies ..................................................................... - 82 -

Annex 5c. Labor Policies ...................................................................................... - 96 -

Annex 5d. Trade Policy ...................................................................................... - 112 -

ANNEX 6. POVERTY AND SOCIAL IMPACT REVIEW ................................ - 122 -

ANNEX 7. MEXICO AT A GLANCE ................................................................. - 134 -

ANNEX 8. MAP IBRD 33447R ........................................................................... - 137 -

i

LOAN AND PROGRAM SUMMARY

The United Mexican States

Economic Policies in Response to the Global Crisis Development Policy Loan

Borrower The United Mexican States

Implementing Agency

Ministry of Finance and Public Credit

Financing Data

US$1.504 Billion, IBRD Flexible loan, in US dollars, with a variable spread and a single repayment on November 15, 2021.

Operation Type Single Tranche Development Policy Loan

Main Policy Areas

Economic Policy, Public Sector, Financial Sector, Trade

Key Outcome Indicators (by December 31, 2010)

Fiscal Policy and Public Expenditure Management • Non oil tax revenue as a percent of GDP has been increased to 10.3

percent in 2010 (Baseline 10.0 percent, 2008) Financial Sector Support • Number of total outlets (including bank branches) that provide

banking services has increased by 35 percent (Baseline 2008: 10,354) • Two independent evaluations of development banks have been

conducted • Increase in the average quality of information (as measured by

CONDUSEF’s “Calificador”) provided by financial intermediaries to users of: (i) credit cards: 9.0 (Baseline June 2009: 8.0), (ii) checking accounts: 8.5 (Baseline June 2009: 7.8), and (iii) mortgage loans: 8.5 (Baseline June 2009: 7.7)

• Publication of impact indicators of development banks in reaching the targeted population

Employment Support • The annual average of beneficiaries hired under the temporary

employment program over the 2009-2010 period has been 600 thousand people (Baseline: 365 thousand, 2008)

• The annual average of work-shifts hired under the temporary employment program has been 32.5 million shifts (baseline: 11.9 million, 2008)

Trade Reform • A reduction in the average tariff for manufactured imports to 5.3

percent (Baseline: 10.4 percent, 2008)

• 61 percent of the tariff line for imports of manufactured goods have a zero rate import duty (Baseline: 20 percent, 2008)

ii

Program Development Objective(s) and Contribution to CPS

The Program Development Objective is to support economic policies to mitigate the impact of the global crisis and strengthen the medium-term framework for sustainable economic recovery and growth. The program will contribute to achieving this objective by further developing the regulatory, monitoring and financial framework for fiscal and financial sustainability, labor market efficiency, and trade liberalization.

The four main Policy Areas of the DPL are:

• Implementation of countercyclical fiscal policies during 2009 while adopting measures to enhance medium-term fiscal sustainability for 2010 and beyond, including an increase in non-oil tax revenue and improvements to public expenditure management;

• Implementation of regulatory reforms to foster financial sector access, consumer protection and stability;

• Enhancement of short-term employment support programs while developing medium-term reforms for labor market efficiency and labor productivity; and

• Improving competitiveness by lowering international trade costs via reduction of Most Favored Nations (MFN) tariffs and simplification of the trade tariff regime and customs processes.

The CPS envisaged an annual multi-sector DPL. This DPL is consistent with this strategy though the Bank has significantly increased the amount of lending following the onset of the global crisis. This DPL supports key actions of Mexico’s National Development Plan (NDP)—as revised in reaction to the global crisis. The government is using the global crisis as an opportunity to display its renewed capacity to conduct countercyclical policies to confront the crisis, while simultaneously advancing key structural reforms on the fiscal, financial sector, labor and trade areas that are central to medium-term development. Some of these reforms, e.g., the increase in non-oil tax revenues on a permanent basis, address some of the most contentious policy issues in recent decades.

While a stand-alone operation, the proposed DPL is part of broader and an ongoing World Bank programmatic engagement which includes knowledge and coordination services to support the government’s medium term economic policy agenda

Risks and Risk Mitigation

A key risk to the success of the operation relates to the potential for substantial modifications by Congress to the policy program and budget law submitted by the administration in September 2009. The specific risk would be a deterioration of the fiscal position in 2010 that may result from the budget ultimately approved by the legislative. Structural medium-term revenue enhancing measures may or may not be approved by Congress. Factors mitigating this risk include (a) the government’s on-going intensive negotiation and public dissemination efforts, (b) an emerging national consensus about the need for a reduction of dependence on volatile oil revenue, and (c) the possibility that the executive may implement alternative policies under its control, if required.

A weak global recovery from the current sharp downturn in economic activity represents another important source of risk to the operation. A “double dip” recession in the United States—Mexico’s main trading partner—would diminish the Government’s ability to maintain expenditure levels for key social and infrastructure programs. The factor

iii

mitigating this risk is that the Government has confirmed its commitment to the policies and reforms supported by the DPL—as evidenced by their prominence in its economic program. In addition, the Government has requested complementary technical assistance loans from the World Bank in public expenditure efficiency and customs administration to support implementation of the reform program. The Bank continues an active knowledge services agenda in fiscal, financial sector and labor policy reforms. A possible follow-up development policy loan in FY11 would support continued reforms.

Operation ID P118070

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MEXICO ECONOMIC POLICIES IN RESPONSE TO THE GLOBAL CRISIS DPL

I. INTRODUCTION

1. Mexico is on the frontline of the global economic crisis. The country shares a common border with the United States, over which more than 80 percent of its exports is exchanged. Millions of Mexican emigrants live in the United States, and prior to the crisis, they sent home over $25 billion per year in remittances. A number of important financial institutions are subsidiaries of international banks that were at the epicenter of the financial crisis. Tourism and other service exports also have the United States as a prime consumer.

2. While the crisis started in the United States, its impact has been more heavily felt in many areas in Mexico. Trade has declined by about 30 percent in the first half of the year. Remittances have fallen substantially, 12.6 percent—in dollar terms—in the first seven months of the year, and foreign investment—direct and portfolio investment—declined by 45 percent in the first half of 2009. The impact of these external factors on the overall economy has been substantial: GDP in the first half of the year declined 9.2 percent compared to a year earlier and the Mexican economy lost more than half a million jobs between June 2008 and June 2009.

3. The current moment is an historic one for economic policy making in Mexico. The Government is using the global crisis as an opportunity. It is an opportunity to display its renewed capacity to conduct countercyclical policies to confront the crisis, while simultaneously advancing key structural reforms that are central to medium-term development. This approach is evident in a variety of areas. The initial countercyclical fiscal stimulus will be gradually withdrawn while non-oil tax revenues are increased on a permanent basis. This represents a major achievement as one of the most contentious areas of policy making in recent decades has been overcome. The financial system has weathered the global crisis relatively well—due in large part to previous regulatory and institutional reforms—and the authorities continue to monitor the system closely. At the same time, the Government is putting in place additional measures to further strengthen the regulatory framework for stability, access and consumer protection. In terms of labor markets, the Government has increased substantially temporary programs to alleviate the impact of the recession, while at the same time preparing a reform of the national labor law—a law that has remained largely unaltered in over thirty years. On the trade front, during a period of heightened global protectionist tensions, the Government has also progressed in trade liberalization—evidence of its commitment to the global public good of free trade.

4. The Government has requested this proposed Development Policy Loan, for the amount of US$1.504 billion, to support implementation of its response to the ongoing global economic recession and broader program of reforms. The proposed loan would support the Government’s core economic policy implementation during the economic downturn—the fiscal, financial, labor market and trade policies that both

- 2 -

combat the crisis and provide the basis for renewed economic growth. As a result of Mexico’s strong track record of macroeconomic policies, the IMF’s Board of Directors approved the first Flexible Credit Line (FCL) for Mexico in April of this year. The FCL provides access to approximately US$47 billion as a backstop to Mexico’s international reserves and thus mitigates the risk of stress in the balance of payments or speculative attacks on the currency. The FCL and budget support from the World Bank and Inter American Development Bank provide complementary multilateral financial assistance during the global downturn.

5. The proposed operation is a central element in the implementation of the 2008 Country Partnership Strategy (CPS). The CPS proposed an annual DPL to support the Government’s National Development Plan, combined with an expanded and flexible program of knowledge and coordination services. The latter would inform the annual DPL and also assist the Government—via an array of analytical and advisory activities—in solving technical problems associated with its policy reform and institutional development agenda. Since the onset of the global crisis, clearly the World Bank’s lending program has expanded both in volume and in scope, with a blend of DPLs and investment loans to provide both financing and more intensive technical support during a difficult period.1 This proposed DPL follows the spirit of the original CPS in terms of its close links to the Government’s program, the multi-sector nature of the policy areas, and the reliance on a strong set of knowledge and coordination services to support the design of the DPL.

6. The proposed DPL is based on a broad programmatic engagement that includes substantial knowledge services to support preparation and implementation of economic policies. These knowledge services involve a blend of instruments, as laid out in the CPS, including strategic studies, on demand/fast response policy advice, permanent long-term advisory role, convening power, monitoring and evaluation of policies and programs, and implementation support.2 For example, fiscal policy has been supported by intensive dialogue on results informed budgeting drawing on international experience in this area. Reforms of the financial regulatory system and development banks were informed by the joint Bank-Fund Financial Sector Assessment Program (FSAP) and FSAP Update, as well as subsequent programmatic non-lending technical assistance (NLTA) on financial sector issues. Bank staff has worked closely with the Ministry of Labor (STPS) on evaluating the impact of the labor reform policies. Bank staff is also working with the customs agency on institutional reform to facilitate trade. These examples illustrate the support of the programmatic knowledge services to the institutional and policy reform program supported by the proposed loan.

1 More details on implementation progress of the CPS has been provided in Annex 8 of Report 49491-MX Framework for Green Growth DPL to be discussed by the Board on October 20, 2009. 2 Report No. 42846, Country Partnership Strategy for the United Mexican States, March 2008, page 17.

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II. COUNTRY CONTEXT

Recent Economic Developments in Mexico3

7. Mexico has been hit hard by the global economic recession. Despite a strong track record of sound macroeconomic management and stable economic conditions over the last several years,4 the Mexican economy stands out as the Latin American country most affected by the global recession. Economic activity declined by 9.2 percent during the first half of the year and the current base case scenario projects a contraction of annual GDP by 6.8 percent in 20095 before a modest rebound of economic activity in 2010.

8. The severity of the current crisis has surprised many. The most important channel through which the global crisis hit Mexico has been the collapse in trade with the United Sates. The United States is the destination of more than 80 percent of Mexican exports and the Mexican manufacturing industry is highly integrated into the industrial production of the United States. A plausible explanation for the much sharper decline in GDP in Mexico compared to the United States is that both trade and industrial production make up a significantly higher portion of the Mexican economy.

9. The current economic recession is characterized by a sharp contraction in aggregate demand. In addition to a collapse in external demand and international trade, the rapid tightening in domestic demand can be attributed to increased uncertainty regarding global and domestic economic prospects, increased unemployment, reduced availability of credit and significant currency depreciation. During the first semester of this year, households and businesses responded to the deteriorated financial and economic outlook with a contraction in private consumption of 9.2 percent and private investment of 11.5 percent compared to the same period of the previous year. Even though the decline in trade triggered the overall economic contraction and exports and imports are both down by more than 30 percent in nominal dollar terms6, the net trade balance is not a source of retrenchment of aggregate demand.

10. In response to the severe recession, the Mexican authorities have increased public expenditure to counter the sharp contraction in private aggregate demand. Contrary to previous cyclical downturns, the sharp fall in public sector revenue observed in 2009 has initially not been associated with a reduction in public expenditure or an

3 A detailed assessment of recent economic developments and outlook is presented in Annex 4 Macroeconomic and Debt Sustainability Assessment. 4 Mexico’s GDP growth averaged 3.8 percent during 2004-2007 and the economy enjoyed a stable currency, inflation of 3.8 percent in 2007, low levels of external indebtedness as a share of GDP, declining public debt ratios and a sovereign credit rating two notches above the lowest investment grade. 5 GDP projections for the third and fourth quarter of 2009 show a rebound of economic activity with positive quarterly growth, based on seasonally adjusted quarter-on-quarter GDP growth rates. The depth of the economic recession is likely to keep the level of GDP-in real terms-in the third and fourth quarter of this year below the level observed in the same period of the previous year. 6 There is a close link between the two with more than 70 percent of import used as inputs for export production.

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increase in taxes and, in that way, fiscal policy is allowing automatic stabilizers to function. Fiscal discipline and strong fiscal policy frameworks, including the establishment of stabilization funds and the acquisition of oil price hedges, enabled the authorities to conduct an adequate countercyclical policy response for 2009.

11. The authorities also have taken appropriate actions to maintain order in foreign exchange and domestic financial markets. The central bank intervened in foreign exchange markets providing foreign currency liquidity to the private sector though, eventually, the level of reserves by the end of this year is expected to be similar to the one observed previous to these currency interventions. Indicators of foreign reserve adequacy continue well above conventional thresholds relative to short-term external debt or imports. Bilateral and multilateral support, through a US$30 billion currency swap arrangement with the US Federal Reserve (recently extended until February 2010) and a US$47 billion Flexible Credit Line (FCL) with the IMF, provide additional precautionary sources of external funds. Announcement of the FCL last April greatly reduced volatility of the peso.

12. The Central Bank also started easing monetary policy in January 2009. The reference rate was lowered from 8.25 percent to the current level of 4.50 percent—achieved in July 2009. Monetary policy is taking place within an inflation targeting framework with a medium-term target of 3 percent. The inflation rate has been on declining trajectory since the end of 2008.

13. The banking system appears sound and is well supervised. Commercial banks are currently well capitalized with an aggregate capital adequacy ratio of 16.2 percent at the end of June 2009—well above the required minimum ratio of 8 percent7. Non-bank financial institutions (NBFIs) are relatively small and unlikely to cause systemic instability. Concerns, however, persist regarding the health of some NBFIs.

14. The turmoil in international financial markets has had a considerable impact on corporate sector access to financing. Increased risk aversion and global deleveraging made it difficult even for large companies to issue debt overseas, and the cost of such borrowing became substantially higher. In the domestic market, the slowdown in credit growth began in early 2008, and overall credit growth stalled by the second half of 2009. The Government reacted by mobilizing its development banks to facilitate the continued flow of credit through private financial institutions, thus preventing a sharper contraction in credit.

Macroeconomic Outlook and Debt Sustainability

15. There seems to be an emerging consensus that the global economic downturn is currently bottoming out, even though uncertainty remains with respect to the strength of the rebound. Assumptions regarding the evolution of the external

7In addition, early warnings are triggered when the capital adequacy ratio goes below 10 percent leading to an intervention by CNBV and coordinated planning for capitalizing the bank until the capital adequacy ratio reaches 10 percent.

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environment have a major impact on the projection of Mexico’s main macroeconomic variables. A base case scenario follows the Bank’s September 2009 Unified Survey Assumption for global economic activity.8 The simulated impact of such assumptions on the Mexican economy is a significant recession in 2009 and a modest rebound by 2010 and 2011.

16. A gradual recovery of economic activity is expected for 2010. The projected recovery in 2010 is modest compared to the depth of the recession observed in 2009 and the economy is expected to operate well below its level of potential output until at least 2012. Risks to this scenario are largely external. A “double dip” recession in the United States would have a significant impact on Mexican growth prospects, if materialized.

Table 1 Main macroeconomic indicators, 2008-2012

Source: Bank staff estimates

17. The sharp external trade adjustment is not generating pressures on the external balances of the economy. The collapse in exports was more than compensated by the decline in imports. There is a substantial component of imported inputs in the production of manufactured exports. Weak domestic demand has further depressed imports. External debt is projected to remain below 25 percent of GDP while the term structure of that debt does not pose major risks for the balance of payments.

18. The main assumptions for the 2010 public sector budget proposal include: an economic growth of 3.0 percent, an average oil price for the Mexican mix of oil exports of US$ 53.9 per barrel9 and a reduction in the volume of oil production to 2,500 thousand barrels per day. Oil production is falling steeply as only four years ago production was still 30 percent higher at 3,256 thousand barrels per day.

19. The Government estimates a shortfall in fiscal revenue in 2010 of 2.9 percent of GDP (374 billion pesos, see table 2).10 Part of the revenue shortfall is due to a “transitory” issue, namely that GDP will remain below potential as the recovery is expected to be slow. The structural component of the deficit is caused by lower oil revenue—lower oil prices and declining oil production. The Government’s budget

8 World output is projected to fall by 2.5 percent in 2009 and experience a gradual recovery in 2010 when growth is expected to be 2.3 percent. Similarly output in the United States is projected to contract by 2.5 percent in 2009 before rebounding by 2.3 percent in 2010. 9 The recent increase in oil prices raised the budget reference price for oil to US$59.0 per barrel. 10 A more detailed analysis of Mexico’s fiscal policies and challenges is included in Annex 5a.

Indicator 2008 2009 2010 2011 2012Real GDP (% ) 1.4% -6.8% 3.0% 4.0% 4.2%

Investment (% ) 5.3% -14.1% 5.0% 6.1% 8.4%

Current Account Balance (% of GDP) -1.5% -1.5% -1.6% -1.8% -1.9%

PSBR Balance (% GDP) -2.1% -2.7% -3.1% -2.8% -2.5%

Inflation (e.o.p.) (% ) 6.5% 4.6% 3.6% 3.3% 3.0%

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proposal compensates a substantial part of the transitory shortfall with non-recurrent revenue—inter alia withdrawals from its stabilization funds. In addition, the proposal also allows part of the transitory shortfall to result in a temporary fiscal deficit of 60 billion pesos or 0.5 percent of GDP. Meanwhile, the Government will address the structural gap with non-oil tax revenue enhancing measures aimed at increasing revenues over the medium-term.

Table 2: Public Finance Policy Measures 2010 (billion pesos)

Source: Ministry of Finance General Criteria for Economic Policy, 2010

20. A series of non-oil tax revenue enhancing measures are being adopted to cover the structural component of the revenue shortfall. Public revenue enhancing measures aim to broaden the tax base and to enhance non-oil revenue through changes in the regime for excise taxes, income taxes, the tax on cash deposits in the banking system and the introduction of a new consumption based tax. The government’s proposal had estimated to raise 176 billion pesos, 1.4 percent of GDP, from the non-oil tax revenue enhancing measures. As a result of revenue enhancing measures—and a modest recovery of economic activity—non-oil tax revenue were projected to increase to 10.8 percent of GDP in 2010 from 9.3 percent in 2009.11

21. The Government’s strategy is to keep the level of programmable federal public sector spending in 2010 at a similar level in real terms in spite of the sharp reduction in inertial revenues. In subsequent years expenditure growth would be in line with the growth in economic activity. Based on an expected return of the economy to potential output by 2012, the Government plans for temporary deficit financing for a two-year period, 2010 and 2011, while returning to a balanced budget by 2012.

22. The Government’s proposal to enhance non-oil tax revenues demonstrates a broad commitment to longer-term fiscal sustainability. Credit rating agencies have warned that there is the need for a clear and credible medium-term fiscal strategy of revenue-enhancing measures or sustainable spending cuts to compensate for lower public sector revenue. The proposed fiscal package seeks to strike a balance between the need for fiscal consolidation to assure markets of fiscal sustainability while smoothing out the withdrawal of fiscal stimulus.

11 At the time of writing, the lower House of Congress adopted a Revenue Law that substitutes the consumption tax for an increase in the general Value Added Tax rate and reduces the tax revenue enhancement by 56.3 billion pesos. As a result, estimated non-oil tax to GDP is reduced to 10.3 percent.

Total 374 Total 374Transitory component 155 Transitory measures 155

Public Deficit 60 Non-recurrent revenue 95

Permanent component 219 Permanent measures 219 Revenue enhancing measures 175.7 Net reduction programmable spending 74.2 Net increase non-programmable spending -30.9

Revenue shortfall compared to 2009 Compensating measures

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23. Inflation has been falling and the central bank expects to reach its medium-term inflation target towards the end of 2010. Inflation expectations remain well anchored, though the revenue raising measures in the fiscal package provide an additional challenge to the monetary authorities to assure that their impact on headline inflation remains a one-off event.

Table 3. Net Public Sector Financing Needs

Source: Bank staff estimates

24. In order to reduce pressures on domestic financial markets, the Government is looking to finance a substantial share of its Public Sector Borrowing Requirements (PSBR) externally. The net financing requirements of the Government are US$23.8 billion and US$28.4 billion in 2009 and 2010, respectively. The Government is planning to finance a larger fraction of the PSBR externally and has requested support from the multilateral development banks—World Bank and Inter-American Development Bank—to finance the major part of its external net financing requirements12 in 2009 and 2010 (US$7.4 billion and US$8.8 billion respectively in Table 3).

25. Net public debt, at just over 40 percent of GDP, remains within manageable proportions despite a modest increase in the debt-to-GDP ratio projected through 2011. Debt sustainability analysis, based on average levels of economic growth, the primary balance and the real interest rate on public debt observed over the past decade shows a return to a downward path of the debt-to-GDP as of 2012.13

26. Notwithstanding the significant challenges posed by the global economic downturn, the macroeconomic policy framework is considered adequate for the purposes of the proposed Development Policy Loan. This DPL supports adequate economic policies to mitigate the impact of the current economic recession and to strengthen the framework for sustainable economic recovery and growth.

12 The Government also faces foreign currency denominated public debt repayments of US$13 billion and US$ 12.5 billion in 2009 and 2010, respectively, which it is planning to refinance on global, private markets. 13 Values for the variables used in the debt sustainability exercise include: growth average 3.1 percent, standard deviation 2.07 percent; primary balance (adjusted for off-balance expenditure and excluding non-recurrent revenue) average 0.55 percent, standard deviation 0.69 percent; and real interest rate 3.3 percent.

US$ billion as a % GDP US$ billion as a % GDP US$ billion as a % GDP

UsesPSBR -22.4 -2.1% -23.8 -2.7% -28.4 -3.1%

SourcesInternal -16.7 -1.5% -16.4 -1.9% -19.6 -2.1%

External -5.7 -0.5% -7.4 -0.8% -8.8 -0.9%

2008 2009 2010

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III. THE GOVERNMENT’S ECONOMIC POLICY PROGRAM AND PARTICIPATORY PROCESSES

27. Sustained policy and institutional reforms have resulted in substantial social and economic progress in Mexico since the 1995 “Tequila” crisis. Macroeconomic stability was restored, total factor productivity began to grow and the financial system was rebuilt on a sustainable basis. Policy reforms formed the basis of this recovery with the elimination of fiscal imbalances, a decline in the public debt to GDP ratio and the development of sound regulatory and supervisory arrangements for the financial system. Monetary policy credibility was established with an inflation targeting regime and inflation was reduced to the single digits. Extreme poverty declined from 37 percent in 1996 to 14 percent in 2006.14 Renewed macroeconomic growth was a fundamental determinant in poverty reduction while, at the same time, social programs were expanded and improved. In fact, Mexico was a pioneer in the development of conditional cash transfer programs with the Oportunidades (formerly Progresa) Program.

28. The global crisis, however, threatens the progress that has already been achieved. The Mexican economy had transformed its export base from a dependence on petroleum products to manufacturing goods; however, the destination of these exports was concentrated on the United States—leaving the economy exposed to the epicenter of the global economic crisis. Furthermore, export goods are largely consumer durables—a segment of aggregate demand that was particularly affected by the downturn in the United States. Investment in dynamic export sectors would suffer as a result of the downturn, and job losses would inevitably have an impact on poverty rates. In addition, the headcount poverty rate had already started to increase during 2008—driven by food price shocks in the early part of that year. Credit to the private sector was also constrained, as banks became more hesitant to lend and even hoarded liquidity. In brief, the global crisis has threatened to create a downward spiral with dire social consequences. Immediate action was needed to mitigate the impacts of the external shock but without departing from the broad policy direction and objective framework laid out in the 2007 National Development Plan.

29. The Calderón administration established its medium-term development program in the national development plan (Plan Nacional de Desarrollo—PND) presented to Congress in 2007. The PND was based on five pillars: economic competitiveness and job creation; public safety and the rule of law; effective democracy; equality of opportunity; and environmental sustainability. The proposed DPL is particularly focused on the first pillar. Several elements of that pillar are particularly closely linked to the policy areas proposed for this operation.15 fiscal reform for competitiveness, efficient financial system, promotion of employment, and the promotion of productivity and competitiveness.

14 National headcount poverty rate based on the ability to provide for basic nutrition needs (Pobreza Alimentaria). 15 For more details, see http://pnd.calderon.presidencia.gob.mx/economia-competitiva-y-generadora-de-empleos.html.

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30. As noted in the introduction, the Government has used the global crisis as an historic opportunity to deepen and accelerate medium term structural reforms. Fiscal policies were adjusted to create additional stimulus expenditures in the short-term, while tax reforms are being proposed to enhance non-oil revenues over the medium-term. Financial sector policies were adjusted to address the lessons learned from the global financial crisis while also refining existing regulations to support consumer protection and access to finance. In the labor area, temporary work programs were expanded while the Government continued to prepare a broad reform of the labor code. Trade had been an important engine of growth in recent years, and the Government continued throughout the crisis period to move towards an even more open and transparent trade regime. The latter is itself an important element in promoting lower costs to firms and improved productivity.

Figure 1: Contribution to Growth (year-on-year)

Source: Bank staff estimates based on National Account Statistics, INEG

31. In general, the Government response can be divided into four main policy areas: fiscal, financial sector, labor market and trade. Fiscal policies for 2009 and 2010 are moderately expansionary. The “moderate” qualifier is due to the limitations imposed on a Government that has a credit rating two notches above lowest investment grade, and the need for maintaining low cost access to credit as part of the Government’s medium term development strategy. The Government executed higher expenditure levels in the first half of 2009 (relative to the previous year)—most notably by increasing investment expenditures in real terms at a double digit pace. As noted in the figure below, increasing expenditure levels did have an effect on offsetting the decline in GDP emanating from the impact of external shocks on private aggregate demand. The Government faces a delicate balance moving forward. Despite potential benefits from continued fiscal stimulus, there are medium term fiscal issues that need to be addressed as fiscal policy adjusts to the post-crisis period. In particular, there is the longstanding

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dependence on oil sector revenues, and declining production will require additional non-oil sources of revenue. As noted in more detail below, the new budget law presented to Congress calls for a new consumption tax16 as well as higher income tax rates and higher excise taxes.

32. In addition, the Government has set in place mechanisms to improve the quality of public expenditures. The fiscal reform of 2007 developed a comprehensive approach to improving the budget cycle (Ciclo Hacendario). This approach implies changes from the fundamentals of accounting to management and information systems to results monitoring for budget execution and impact evaluation of specific programs. Institutional development of this nature takes time; however, the approval of the new Governmental Accounting Law is a key step in the process.

33. The financial sector policy response concentrated on resolving limited potential gaps in the regulatory framework, measures to bolster access to finance, as well as market-friendly measures by development banks to maintain credit during the global crisis. The global financial crisis has shown that the regulatory and supervisory system in Mexico is quite strong in terms of assuring systemic stability. That said, the Government took advantage of the lessons of the recent global financial crisis to reinforce the regulatory system with new measures. Consumer protection norms have been strengthened to help avoid predatory lending practices. These measures also assure greater transparency in lending and can help foster broader access to credit. The Government also secured legal reforms to assure the companies provide information on derivatives positions. Legal amendments were also passed to facilitate the development of banking agent services—a promising approach to improved access to financial services. Finally, the Government made effective use of the reformed and healthy development banks to counteract the tight liquidity conditions and facilitate the continued flow of credit through private financial markets.

34. On the employment front, the Government expanded those active employment programs that had proven effective. Spending for temporary employment programs more than doubled during the first half of 2009 (compared to the first half of 2008), and the coverage of the programs was expanded to urban areas where the crisis hit hardest in terms of job losses and unemployment. The National Employment Service was also allocated additional resources to attend more workers with job training and job placement services. Finally, the Government expanded the scope for unemployed workers to use personal savings in individual retirement accounts for consumption smoothing during the recession.

35. The Government reiterated its long term commitment to trade liberalization by lowering Most Favored Nations (MFN) tariffs on manufactured imports and simplifying the tariff regime and customs procedures for international trade. This reform will lower the cost of integrating into global supply chains as it will be less costly for firms, in particular SMEs, to access imported inputs from the most efficient sources.

16 See also footnote 11, page 6.

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In addition, reduced cost of some consumer goods is expected to increase welfare of consumers, in general. It should be noted that this reform represents a commitment to the global public good of free trade, during a period of growing protectionist pressures internationally.

36. The fiscal and labor policy measures, the support of development banks and infrastructure measures were presented in the National Agreement in Favor of the Family Economy and Employment (ANFEFE--Acuerdo Nacional a Favor de la Economía Familiar y el Empleo). For 2009, the Government estimates that the overall direct economic impact of the ANFEFE package of measures is on the order of 1.4 percent of GDP.17 The public investment programs, energy price reductions and development bank support are the three largest elements in terms of their estimated impact.

37. The short-term policy response is embedded in the Government’s medium term development policy agenda. On the fiscal front, the Government has established non-oil tax revenue enhancement and improved efficiency of Government expenditures as key objectives over the medium-term. As the economy slowly emerges from the recession, the adjustment towards fiscal balance requires new tax measures—as proposed in the 2010 budget—that would increase non-oil tax revenues. In addition, the improved monitoring and evaluation techniques have been used to streamline expenditures while securing or even expanding programs that have shown to provide better results. In terms of financial sector reforms, the Government is working to strengthen further the regulatory and supervisory system, while continuing to promote competition and access to finance within a framework that provides adequate consumer protection. In terms of labor policies, the Government has already prepared a broad labor reform proposal that would promote greater efficiency in labor court procedures, as well as introducing new apprenticeship modalities for labor contracts. Finally, trade liberalization is a key element in the broader competitiveness agenda, as noted in recent opinions issued by the Federal Competition Commission.18

Consultative and Participatory Processes in Mexico’s Economic Policy Formulation

38. Mexico’s economic policy program is built on a consultative process that started with the NDP. The plan was formulated on the basis of ample consultations that included extensive focus groups and surveys, the findings of which were made publicly available.19 The NDP process highlighted inter alia the need to strengthen tax revenue

17 See “Perspectivas Económicas para 2009 y el Acuerdo Nacional en Favor de la Economía Familiar y el Empleo”—presentation by SHCP to Congress, February 2009. 18 See “Opinión con el fin de promover la aplicación de los principios de competencia y libre concurrencia en el diseño y aplicación de políticas y regulaciones del comercio exterior de mercancías” Comisión Federal de Competencia, May 2008. 19 The plan, a description of its consultative process and the results of those consultations can be found at http://pnd.calderon.presidencia.gob.mx. The consultative process included 205 workshops with a participation of 51,997 citizens. In addition 79,921 citizens participated individually by sending their proposals and comments.

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bases and enhance public expenditure management; foster access to finance while maintaining a stable financial system; and enhance competitiveness by facilitating trade.

39. The economic policy program in response to the global crisis, ANFEFE, was announced by President Calderón on January 7, 2009 as an agreement among different sectors of Mexican society. In recognition of the seriousness of the international crisis, the office of the President initiated a series of consultations with the most important sectors of the Mexican economy and society during the last quarter of 2008, so that a concerted response to the adverse economic environment could be convened. The agreement included a series of policy actions to be adopted by the Federal Government during 2009, as well as a string of commitments on the part of several public and private Mexican institutions. The agreement includes commitments by the Federal Government, the Congress, heads of the Executive of Federal States, as well as labor and business organizations. The agreement was signed by a large set of high-ranking officials of these institutions. The five pillars included in the agreement are: (i) Support to Employment; (ii) Support to Mexican Families; (iii) Support to Industry and SMEs; (iv) Support to Infrastructure Investment for Competitiveness and Employment; and (v) Transparent and Efficient Public Expenditures. The proposed operation supports important elements of the first, third and fifth pillars. Other Bank operations support other elements of this plan as well.

40. The Ministry of Economy conducted a series of consultation processes with regard to the reductions in the MFN tariffs and simplification of customs processes. These were concentrated on a specific number of industries and business chambers due to the breadth of the reform. Further communication with stakeholders throughout the implementation of the program through 2013 will likely be necessary to further explain the benefits of lower tariffs in terms of the simplification of the trade regime and competitiveness.

41. Finally, Mexico’s multi-branch Government and competitive political system provides a framework for ample discussion of Government proposals. In the fiscal area, the proposed revenue and expenditure laws that comprise the budget package are subject to a calendar of preparation (April-August), presentation (early September) and eventual approval by Congress (mid-November) that allows for ample and active deliberations of the proposal and the presentation of counter-proposals by the elected representatives in Congress as well as discussions among business chambers, unions, civil society, special interest groups and the public in general. In the financial sector area, the discussions of technical decrees and regulatory norms were conducted with professional finance associations that are likely to be impacted by the reforms. In the labor area, the Government signed a National Agreement on Labor Productivity with labor groups and it also had a consultative process with worker and firm representatives regarding the preparation of a reform of the Federal Labor Law taking into account the many proposals that have been submitted by different groups in recent years. Moving forward, the Government has been introducing ideas for reform of the labor law to the general public during public presentations and on the ministerial website (www.stps.gob.mx).

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IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM

Link to Country Partnership Strategy

42. The Country Partnership Strategy (CPS) was discussed by the Board in April 2008, and it proposed a highly flexible program of assistance for Mexico. The partnership was based on a continued lending program on the order of US$800 million per year; however, the CPS envisioned that the overall program could be adjusted upward depending upon market circumstances. Another principle established in the CPS is that the Bank’s program should be closely aligned to the Government’s own development strategy. Given the still strong market access for Mexico at that time, and continued demand for knowledge services from the Bank, it was proposed that the lending program be simplified into one or a small number of DPLs in order to free up Bank administrative budget for knowledge services and strategy and coordination activities.

43. Market conditions have changed since April 2008, and the Government—as noted above—has made adjustments to its development policies. The Bank is responding positively to the Government’s request for a substantially higher volume of lending. In the spirit of the CPS, the proposed Economic Policies in Response to the Global Crisis DPL is to support the Government’s policy measures to respond to the challenges posed by the global crisis, while also advancing in the medium-term reform agenda. In this sense, it is essentially the broad based annual DPL that was foreseen originally in the CPS.

Summary Update of the Implementation of the CPS

44. The flexible design of the CPS has facilitated timely and effective Bank response with total lending in FY09 reaching US$3.4 billion.20 The framework for moving forward, agreed with Mexico, includes a major effort to alleviate the expected human consequences of the economic downturn, as well as efforts to promote the basis for gradual reactivation of the economy by strengthening the financial sector, supporting investment in infrastructure and climate change, and enhancing governance and countercyclical measures.

45. The Government of Mexico has requested access to US$5 billion in CY09 and would like to access a further US$5 billion in CY10 of IBRD lending as conditions of access for emerging market economies to international capital markets have deteriorated following the global financial crisis. In response, US$6.7 billion in new lending commitments is proposed for FY10. Together with ongoing operations, this is expected to yield around US$7.7 billion in disbursement during CY09-10, with exposure increasing to around US$12.5 billion by FY12-13, depending upon the pace of implementation. The composition and level of the lending program for FY11 will be developed in the coming year with due regard for client needs and dependent on IBRD’s overall lending capacity. 20 As referred in footnote 1 a previous update was prepared for the Framework for Green Growth DPL, Report 49491-MX, Annex 8 to be discussed by the Board on October 20, 2009

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46. The IFC will continue to be a strong partner with Mexico as the crisis unfolds, with a focus on investment and advisory activities that complement IBRD efforts to improve the living conditions and economic opportunities at the base of the pyramid. Support includes broadening and deepening the financial sector, infrastructure investments and advice, strengthening of the investment climate, improving the quality of healthcare and corporate governance. Having identified Climate Change as a new priority area of support, the IFC will be working to support investments in renewable energy and energy efficiency projects in concert with the objectives of the Green Growth DPL. In response to the crisis, the IFC is focused on the implementation of systemic interventions, such as the recently announced US$150 million facility to support housing finance. Under current conditions, the IFC has a strong counter-cyclical role to play by partnering with the IBRD and Mexican development banks.

Collaboration with the IMF and other development partners

47. World Bank and IMF staff meet on a regular basis to exchange views on the macroeconomic situation and prospects for Mexico. These consultations occur at least quarterly and also involve exchange of documents and recent reports conducted by the respective teams. Financial sector issues are often discussed as both institutions are actively engaged in policy advice in this area. Other structural issues—for example labor reform—have been discussed during these meetings as well.

48. The IMF's Board approved a Flexible Credit Line (FCL) for approximately US$47 billion in April of this year. Mexico was the first country to qualify and request this new instrument, which is intended to be a one-year arrangement and is treated as precautionary by Governments. This type of support during a global downturn is very much complementary to World Bank and IDB financing of the Government budget. The scale and precautionary nature of the IMF program provides a backstop on international reserves of the Central Bank, thus limiting the possibility of speculative capital outflows that could cause further damage to economic prospects. Meanwhile, Bank financing provides counter-cyclical and long-term financing of Government expenditure and allows the Government to limit crowding out of private sector access to local (and international) capital markets.

49. The Bank has also collaborated with the Inter-American Development Bank (IDB) during loan preparation. The IDB is considering a parallel operation in similar policy areas, and task teams have been exchanging views and sharing documents.

Relationship to Other Bank Operations

50. The Bank is supporting the Government’s countercyclical policy response and medium-term development agenda through a variety of instruments. For example, the development banks are facilitating the functioning of financial markets due to increased risk aversion by private agents, and this is being partially financed by a number of Bank investment loans. Last fall, the Board approved a loan to the Sociedad Hipotecaria Federal that would allow it to restructure its liabilities in order to have the financial capacity to support housing finance during this critical time. An additional

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financing to BANSEFI, approved in late 2008, continues support for another development bank’s activities. There is currently another investment loan under preparation that would support the expansion of lending activities by two other development banks: Bancomext and NAFIN.

51. On the fiscal front, the Bank has been working closely with the Government on performance informed expenditure management. The Government can use its growing array of performance measures to improve the impact of the stimulus and the eventual need for fiscal consolidation in three ways: (a) expenditure prioritization; (b) improving the performance of operational expenditures; and (c) improving the performance of investment expenditures. The Bank is providing a variety of instruments to support efficient, effective and transparent public spending. Two critical Technical Assistance loans were approved last year—one for results based management and budgeting, and another for customs administration. The latter is also important in terms of lowering transaction costs for international trade and thus improving competitiveness. In terms of non-lending services, the Bank is working—on a fee basis—with the Government on improved integrated financial management. There are also fee based arrangements with states to bring the results oriented budgeting initiatives to that level of Government.

52. The financial sector policy area of the proposed DPL follows up on a number of actions previously supported in the First Programmatic Finance and Growth DPL.21 This programmatic series did not move on to subsequent stages as the Government’s demand for IBRD lending diminished during FY07. The reforms supported by that operation helped to create the relatively strong financial system that has shown substantial resilience during the global crisis. In addition, actions to improve prudential regulation and the transparency of financial intermediary operations that are proposed in the financial policy area below clearly build upon the achievements of the earlier Finance for Growth DPL. These reforms complement the support of the development banks mentioned above.

53. In the area of labor policies, the Bank has been providing advisory and analytic services to the STPS. In late 2008 and early 2009, the Bank has been providing STPS with background on international experience with active labor market policies, as well as evaluation of existing Government programs.

54. The Bank is supporting the administrative reforms necessary for lowering the cost of trade via the Mexico Customs Institutional Strengthening project. The objective of the project is to improve the efficiency of customs processes thus contributing to improving Mexico's competitiveness and facilitating trade with foreign parties. This would be accomplished through institutional redesign, training of customs staff and a communications strategy to build consensus for the institutional reform.

21 An ICR for this loan (IBRD-73630) was published in January 2008.

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55. Bank support to infrastructure and social sectors is complementary to the proposed DPL. The Bank also plans to support key components of the infrastructure expenditure plan, as well as associated infrastructure sector reforms that are linked to long term environmental objectives. A loan to finance the urban mass transit systems is in the final stages of preparation. A DPL to support a positive environmentally focused framework for long term sustainable growth has been presented to the Board on October 20, 2009. The Bank is also providing direct financial support to the social safety net. Earlier this year, a large operation was approved to finance the Oportunidades conditional cash transfers, which has increased the monthly transfer amount in response to the food price crisis and economic conditions. A loan to support the Seguro Popular targeted health program is also under preparation. The Bank has also provided timely support for financing the cost of the response to the AH1N1 influenza outbreak. Existing loan funds were quickly reallocated to this issue during the height of the crisis, and the Bank is nearing completion of a loan to finance vaccination and surveillance costs for the upcoming flu season.

Lessons Learned

56. The design of the proposed operation takes into account the lessons learned from the overall program with Mexico, the recent Development Policy Lending Retrospective22 and in general from Bank work with other middle-income countries. In particular, the most important lessons include the following:

a) Operations should be focused and avoid large and complex policy matrices. Rather than seeking to cover an extensive list of measures the design of this DPL has sought to concentrate on those that address the cornerstones of the economic policy response to the global financial and economic crisis.

b) Flexibility to respond to changing circumstances is fundamental. 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 is particularly important in the context of the current global financial and economic crisis.

c) Prior strong analytical work and continued engagement is a necessary precondition. In preparing policy-based operations, the Bank should lead with its comparative advantage which is bringing to bear strong technical capacity and ample cross-country experience. The Borrower must be confident that its dialogue with the Bank will add value to its own efforts. The Bank has maintained a very fruitful dialogue with the Government during the current CPS period, as well as in previous years, leading to the preparation of analytical work that has assisted Mexico in strengthening its performance informed expenditure management and public expenditure monitoring and impact evaluation programs.

22 2009 Development Policy Lending Retrospective, August 2009.

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d) There is the need to take into account the political economy of reform. In designing a policy-based operation, political factors and the legislative needs of the country need to be understood and included in the dialogue with the client. Some of the measures at the concept stage, such as the 2010 budget will still be reviewed by Congress, and the task team will follow this process closely with Government counterparts.

e) Strong country ownership is critical to success, particularly when supporting cross-sectoral efforts, such as those included in the proposed loan. The proposed project responds to Government’s request to support specific priority programs and areas which reflect the outcome of national policymaking processes.

f) Providing just-in-time strategic engagement and support: the Government has repeatedly requested the Bank’s support in the areas of expenditure management, financial sector reform, labor reform and customs administration. The experience with developing and providing comprehensive analytic and advisory packages on those priority issues, through Memorandums of Understanding (MOUs), as a complement to policy lending, has served to ensure that policy development is predicated upon a sound and strategic analytic basis.

g) The commitment of the Government is central in ensuring the success of the program. Previous policy-based and investment operations all pointed to the important role of strong Government leadership in their success. 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 the key policy axes of the Government’s national development plan and the strategy to face the global crisis.

Analytical Underpinnings

Analytical Underpinnings for Growth and Medium Term Reforms

57. Bank analytic work at the global, regional and country level have contributed to the understanding of the growth process and design of medium term economic reforms. Global and regional research reports are actively discussed in policy forums in Mexico: for example, the work of the Growth Commission and regional reports on the determinants of growth.23 Country level analysis has focused on areas like general competitiveness and education.24 A particular effort was made during the political transition to provide inputs to the prioritization of the medium term reform agenda in the form of the Policy Notes: Creating the Foundations for Equitable Growth.

23 For example, see the regional reports, From Natural Resources to the Knowledge Economy, Economic Growth in Latin America and the Caribbean, and The Role of Fiscal Policy for Human Development and Growth. 24 For example, see Mexico’s Competitiveness—Reaching its Potential and Mexico: Determinants of Learning Policy Note.

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The issues of dependence on oil revenue, financial sector development, trade diversification and improved labor market performance were all highlighted in the Overview chapter of this report.

Analytical Underpinnings for the Fiscal Policy Area

58. The Bank has provided fiscal policy analysis at the global, regional and country level that is extremely relevant for the design of the proposed DPL. At the global level, PREM policy papers25 have analyzed the fine balance between fiscal policy response to the crisis and maintaining fiscal sustainability—given varying degrees of policy flexibility. Regional analysis for Latin America has also examined the role of fiscal policy during the crisis, including the development of an index of the scope for fiscal policy adjustment.26 Fiscal responsibility laws in the LAC region have also been studied.27 At the country level for Mexico, a chapter of the 2006 Policy Notes analyzed the use of the fiscal windfall from high oil revenues and the need for increasing non-oil revenue sources.28 The challenge of declining oil revenues was a key issue in the Overview Chapter of the Policy Notes as well.

59. Support to the Government’s efforts to improve the quality of public expenditures is anchored in a solid base of analytical work developed by the World Bank. Extensive analytical work confirms that successful financial management and performance management-oriented reforms must be based on performance evaluation systems capable of tracking and ultimately improving the management of expenditures (Public Expenditure Review FY04), as well as strengthening Government accountability for service delivery to citizens (programmatic poverty analysis series FY04, FY05, FY06). The Institutional and Governance Review (FY07) advised on the need for public information on sector performance as a means to strengthen electoral accountability and democratic governance. The Country Procurement Assessment Review (CPAR FY08), which was produced in coordination with the IDB, offers specific recommendations for improvements to the procurement system, some of which have already integrated in the recently approved amendment to the Procurement Law. The NLTA program on Financial Management, agreed between the World Bank and SHCP, offers concrete recommendations for improving Government accounting standards and systems with the goal of increasing the overall quality and harmonization (across different levels of Government) of budget reports and financial statements. These recommendations were included in the new Government Accounting Law, the enactment and implementation of

25 For example, see Fiscal Policy for Growth and Development: An Interim Report (April 6, 2006) and PREM guidance notes like “The Quality of Fiscal Stimulus in Developing Countries” (December 12, 2008) and “Developing Countries and the Financial Crisis: Vulnerabilities and Fiscal Policy Options” (February, 2009)—both available at the PREM Financial Crisis Collaboration Site). Also see the regional report Fiscal Policy, Stabilization, and Growth: Prudence or Abstinence?, 2008. 26 See LCRCE policy note “How much room does Latin America and the Caribbean have for implementing counter-cyclical fiscal policies” (April 22, 2009). 27 See, for example, “Fiscal responsibility laws for subnational discipline: the Latin American Experience”, WPS 3309, 2004. 28 See the Overview chapter and Chapter 2 of Mexico: Creating the Foundations for Equitable Growth (2007).

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which is supported by this operation. A series of notes highlighting advances in performance informed budgeting have also been produced over the last year.29

60. The Bank’s ongoing and future technical assistance in the area of public sector reform are geared towards a blend of on demand advisory services, TA loans and policy notes. These activities are being coordinated under the MOU concept developed in the 2008 Country Partnership Strategy (see Box 1).

Box 1 MOU for Public Sector ReformThe MoU characterizes recent Government reforms as a 3-pronged strategy:

i. Enhance budgetary discipline by strengthening fiscal planning and accountability to ensure compliance with revenue and expenditure management rules throughout the public sector

ii. Establish a focus on expenditure efficiency iii. Focus on the achievement of key results.

Public sector reform support has focused on the implementation of reforms to the Ciclo Hacendario, the financial management system and supporting the public sector accountability and performance agenda. The technical and financial assistance which is either currently being delivered to the Government or under consideration focuses on:

i. Budgetary discipline: reforms to the Ciclo Hacendario and Financial Management Information Systems;

ii. Performance: a) Performance-informed Budgeting; b) Improvement of Revenue Agency performance; c) Regulatory and Operational Reforms to improve the performance of selected

sectors and agencies; and d) Performance-oriented Judicial Reforms.

Analytical Underpinnings for the Financial Policy Area

61. Financial sector policy issues have also been analyzed extensively by the Bank at the global, regional and country level. DEC Policy Research Reports have laid the framework for financial sector policies globally.30 Regional studies have also examined issues of access to finance, SME lending and capital market development.31 At the country level, the 2002 Mexico FSAP report and the 2006 FSAP Update provided key policy recommendations, including reforms of the structure of the system of development banks. These recommendations were also summarized in the 2007 Policy Notes. More recently, the Government has requested knowledge services via NLTA that studied issues

29 One example is “Institutionalizing Performance in the Public Sector in LAC: The Case of Mexico, En Breve Number 129, July 2008. 30 See Finance for Growth: Policy Choices in a Volatile World (2001) and Finance for All? Policies and Pitfalls in Expanding Access (2007). 31 See “Innovative experiences in access to finance: market friendly roles for the visible hand, WPS 4326, 2007, Emerging Capital Markets and Globalization: the Latin American Experience, 2007 and Bank Involvement with SMEs: Beyond Relationship Lending, 2008.

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of competition in the banking system, new modalities for access to finance, monitoring indicators for development banks and capital markets development. The policy dialogue following the outbreak of the global financial crisis has been led by the LAC regional chief economist and centered on the impact of the crisis on the financial system and lessons on the need for adjustments in the regulatory framework and in particular regarding the perimeter of institutions under prudential regulation.32

Analytical Underpinnings for the Labor Policy Area

62. Bank analysis of labor market issues has also been extensive. The PREM anchor produced an international report on employment and shared growth33, along with the development of new diagnostic tools for country analysis. The LAC regional chief economist’s office has also been actively involved in this research area with key recent reports on job creation and informality.34 Analytic work at the country level has explored income generation for the poor35, and the growth and employment nexus.36 Over the past eight months, the Bank has been working with the STPS in analyzing the labor reform proposal that has been publicly announced by the ministry. A report analyzing the proposal and putting it in international context was presented to the Minister and his team in early September.

Analytical Underpinnings for the Trade Policy Area

63. At the global level, the Bank has been an important advocate for multilateral trade liberalization, providing some of the most cited estimates of the gains from advancing the Doha round of trade negotiations. DEC research has provided empirical evidence on trade and growth links.37 In addition, there have been numerous international research papers on the gains from investments in trade facilitation, including studies on Mexico.38 At the regional level, studies have examined the lessons from NAFTA for the LAC region,39 the potential economic impacts of the Central American Free Trade Agreement (CAFTA),40 and there is a soon-to-be-completed regional report on the quality of trade in the region. At the country level, competitiveness studies41 have laid out the key role of trade in Mexico’s growth prospects. In addition, the Bank has had

32 See also Augusto de la Torre and Alain Ize “Regulatory Reform: Integrating Paradigms”, 2009 World Bank Working Paper no. 4842. 33 Employment and Shared Growth: Rethinking the Role of Labor Mobility for Development, 2007. 34 Job Creation in Latin America and the Caribbean: Recent Trends and Policy Challenges, 2009 and Informality: Exit and Exclusion, 2007. 35 Mexico: Improving productivity for the urban poor, 2009 and Mexico: Income Generation and Social Protection for the Poor, 2005. 36 Mexico: An Agenda for Growth and Employment, 2007. 37 Globalization, Growth and Poverty: Building an Inclusive World Economy, 2002. 38 See for example, “Trade reform promises large gains to trade in Mexico,” World Bank Trade Issues Brief, June 2008. 39 Lessons from NAFTA for Latin American and the Caribbean, 2005. 40 The Challenges of CAFTA: Maximizing the Benefits for Central America, 2006. 41 Mexico’s Competitiveness: Reaching its Potential, 2006.

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an active dialogue on customs reform and institutional development—a key area for trade facilitation.

V. THE PROPOSED OPERATION

Operation Description

64. The Overall Program Development Objective is to support economic policies to mitigate the impact of the global crisis and strengthen the structural medium-term framework for sustainable economic recovery and growth. This will be achieved by further developing the regulatory, monitoring and financial framework for fiscal and financial sustainability, labor market efficiency and trade integration. The four policy areas of the DPL are:

• Implementation of countercyclical fiscal policies during 2009 while adopting structural measures to enhance medium-term fiscal sustainability for 2010 and beyond, including an increase in non-oil tax revenue and improvements to public expenditure management

• Improvement of the regulatory framework to foster financial sector access, consumer protection and stability;

• Enhancement of short-term employment support programs while developing additional medium-term reforms for labor market efficiency and labor productivity; and

• Improving competitiveness by lowering international trade costs via reduction of Most Favored Nations (MFN) tariffs and simplification of the trade tariff regime and customs processes.

65. This DPL is proposed within the framework of the 2008 CPS to conduct an annual multi-sector DPL to support the Government’s key actions of its national development plan (NDP). Due to the global crisis, this DPL focuses on supporting a number of key policy actions in response to the crisis, embedded in a medium-term economic policy reform agenda. This operation is supported by an ongoing programmatic engagement (see Box 2)—including knowledge and coordination services and investment lending—to support the Government’s medium-term economic policy agenda as noted in Section III.

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Box 2. Schematic of Programmatic Engagement: Examples from Two Policy Areas

Fiscal Policy Area

Knowledge Services: Public Expenditure Review (PER)

Infrastructure PER Decentralization and Service Delivery for the Poor ESW Fee-for Service on Financial Management Systems

Policy Notes Results Based Budgeting (RBB) Conference

“MOU” on Public Administration Reforms

Financial Services: TA Loan on Tax Administration

TA Loan on RBB This Proposed DPL Debt management tools and derivative products from WBG Treasury Department

Financial Sector Policy Area

Knowledge Services: FSAP Update NLTA on Competition,

Access and Development Banks Policy Notes

NLTA on Capital Markets Development

Financial Services:

Finance for Growth DPL Access to Rural Finance Loan (BANSEFI development bank)

Private Housing Markets Development Loan (SHF development bank) Additional Financing to BANSEFI

This Proposed DPL Possible future loan to BANCOMEXT/NAFIN

66. The Policy areas supported by the Proposed Operation and key triggers are presented below and a summary of these is presented in Box 3.

Policy Area I: Fiscal Policy and Public Expenditure Management42

Trends and recent developments

67. In the years previous to the current global crisis Mexico observed a significant growth of total public sector revenue and expenditure. The expansion of the public sector has been driven in part by significantly higher oil revenue as oil continues to make up about 36 percent of total public sector revenue. Efforts to raise non-oil tax revenue were initially focused on improving tax administration, but by the end of 2007, these were complemented with changes in tax policy and the introduction of

42 See Annex 5a for a more detailed discussion

2005 2009…Future

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new taxes which led to an increase of close to 10 percent in the ratio of non-oil tax revenues to GDP in 2008. Nevertheless, at less than 10 percent of GDP, Mexico’s tax effort remains substantially below the level observed in other countries in the region or at a similar stage of development.

68. Fiscal policy in Mexico is carried out within the framework of a Fiscal Responsibility Law (FRL) that was adopted in 2006. The FRL strengthened and put into a more permanent legal framework some of the macroeconomic stability oriented features of fiscal policy in Mexico that had been evolving in the context of annual budget formulation and discussion in Congress. The FRL requires budget formulation, approval and implementation to lead to a balanced budget. The FRL also includes an oil revenue stabilization mechanism consisting of a formula to determine the budget reference price for oil and rules on the distribution of excess revenue resulting from an oil price that is higher than the estimated budget reference price.

69. The Government also engaged in a longer term program of public sector management reforms to produce a more efficient and effective public administration. The Government improved its budgetary discipline by strengthening fiscal planning and accountability to ensure compliance with revenue and expenditure management rules throughout the public sector. Efforts to enhance the efficiency, effectiveness and accountability of public spending have been framed in an expenditure performance evaluation system, the Sistema de Evaluación del Desempeño (SED), which establishes methodologies and policies on performance informed management and performance informed budgeting.

Fiscal policies and public expenditure management during the global crisis

70. In the wake of the global crisis the Mexican authorities managed to initially increase and eventually maintain the level of public expenditure to withstand the sharp contraction in private aggregate demand. Contrary to previous cyclical downturns, the sharp fall in public sector revenue that can be attributed to a downturn in economic activity has not been compensated by a sharp reduction in overall public expenditure or an increase in taxes and, in that way, fiscal policy is allowing automatic stabilizers to function. At the same time the Government is recognizing the need for medium term reforms to reduce the reliance on declining oil revenues.

71. While providing for short-term countercyclical measures, the Government’s program is thus also laying the foundations for structural medium-term fiscal sustainability. In addition, it is complementing sustainability efforts with improvements in public expenditure management. The proposed operation would support the Government’s reforms to (i) conduct a counter-cyclical fiscal management program, (ii) enhance non-oil tax revenue; and (iii) improve public expenditure management in particular through the approval and implementation of a Governmental Accounting Law.

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Prior Actions in the Fiscal Policy and Public Expenditure Management are:

• Implementation of countercyclical fiscal stimulus measures during the first semester of 2009 as demonstrated by:

(i) an increase, in real terms, of current spending by 5.4 percent, and (ii) an increase, in real terms, of public sector induced physical capital

investment spending by 27.7 percent compared to the same period of the previous year.

• Submission to Congress of an Economic Program for 2010 outlining a multiannual fiscal policy strategy including:

(i) the creation of new taxes and modification of existing taxes to enhance non-oil revenue; and (ii) a temporary deficit and the use of non-recurrent revenues to compensate for a temporary, cyclical shortfall in public sector revenue.

• Issuance of a General Governmental Accounting Law to harmonize accounting standards among the federal, state and municipal levels of the executive branch of government as published in the Official Gazette on December 31, 2008

72. The preparation, discussion and approval of the budget for 2009 took place at a time of a rapid deterioration in the external economic and financial environment following the bankruptcy of Lehman Brothers mid-September 2008. The approved budget provided for a considerable countercyclical fiscal stimulus to economic activity.

73. Actual budget execution for 2009 has modified the size of the estimated fiscal stimulus. The collapse of the oil price end-2008/early-2009 and the severe global and domestic economic downturn led to an estimated gross revenue shortfall of 478 billion pesos (4 percent of GDP) in 2009. The Government is covering this amount with a transfer of profits from the central bank, receipts from an oil price hedge contracted by mid-2008, withdrawals from the Government’s oil revenue stabilization funds and, eventually, some reductions in public expenditure with respect to its original budget. Based on the adjustments to its program the Government now projects to maintain the level of public spending constant in real terms this year compared to the budget executed in 2008.

74. In order to provide support to economic activity when most needed, the Government front-loaded its public expenditure and investment programs in 2009. As a result, current expenditure and public sector induced physical investment increased by 5.4 and 27.7 percent, in real terms, respectively during the first half of 2009 compared to the same period of the previous year.

75. In its budget proposal for 2010, the Government estimates a revenue shortfall of 374 billion pesos (2.9 percent of GDP), compared to the budget approved for 2009. This shortfall is divided into a temporary or transitory revenue shortfall attributed to a level of economic activity below potential output and a more permanent or structural component due to a reduction in oil revenue as a result of a lower volume of production and a lower budget reference price for oil.

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76. The Government proposes to cover the transitory shortfall to an amount of 155 billion pesos with non-recurrent revenue and additional deficit financing. The latter implies invoking, for the first time since its adoption, a clause in the FRL that allows for a temporary deviation from the balanced budget rule under extraordinary conditions.

77. To cover the structural component of the revenue shortfall in 2010 of 219 billion pesos the Government proposes a series of public revenue enhancing measures. Public revenue enhancing measures aim to broaden the tax base and increase non-oil tax revenue through changes in the regime for excise taxes, income taxes and the introduction of a new consumption based tax. The latter—called “contribution to reduce poverty”—is a tax on the consumption of all goods and services. The revenue collected from this contribution should be allocated, on a priority basis, to poverty reduction programs and, in particular, to conditional cash transfers and social protection programs.43

78. In order to allow a successful implementation of its expenditure performance evaluation system (SED), the Government prioritized the establishment of an overall accountability and compliance framework with public financial management requirements at all three levels of Government. Progress in public expenditure management reforms are being used to guide the reduction and reallocation of public spending. In order to provide accurate, consistent and timely information, required for an adequate operation of the SED, a Governmental Accounting Law was enacted on December 31, 2008 to establish accrual accounting and harmonize the accounting standards among the three levels of Government (federal, state and municipal). The law has an implementation horizon of three years and by 2012 the accounting norms, standards and practices at all levels of Governments should be harmonized and able to issue information in real time.

79. Regarding the implementation of the law, progress has been made in the creation of a national council for accounting harmonization and a consultation committee. In addition, the Government has advanced in the development of the conceptual framework of the governmental accounting, and the norms and methodologies for the determination of the expenditure accounting moments.

80. Consolidation of the performance informed budgeting at the federal level will continue through the end of the current administration. Implementation of the SED, at the different levels of Government, will require substantial coordination with the subnational levels. The states’ initiatives will be strengthened during 2010 particularly due to some specific requirements of the Governmental Accounting Law in terms of physical and financial indicators. These efforts will build upon the progress achieved by the Federal Government in the definition of specific methodologies to measure results that will be very useful in a context of a harmonized framework for the programmatic budget information.

43 See also footnote 11, page 6.

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Policy Area II: Financial Access with Stability44

Trends and recent developments

81. Mexico´s financial sector appears sound and well supervised, but remains underdeveloped relative to other high-middle income countries. Financial depth and access indicators compare unfavorably with both global and regional indicators. The banking sector, for example, is broadly half the size of Brazil’s and Chile’s. In addition, recent surveys indicate that access by the adult population ranges from 45 percent to 60 percent. Many small and medium enterprises (SMEs) remain excluded from the domestic banking sector, and medium- to long-term financing remains a challenge. .

82. In addition, global financial turbulence has had a substantial impact on Mexico´s financial markets and financing alternatives for Mexican companies. Large corporations have found fewer opportunities to issue abroad and costs have been substantially higher. Credit growth by commercial banks virtually halted and declined in real terms in the second quarter of 2009. Tighter credit conditions have made it more difficult for SMEs to secure bank financing as large companies have resorted to domestic bank borrowing. In order to mitigate the effects of the global financial turbulence, the Central Bank eased monetary policy and the Ministry of Finance supported the expansion of the balance sheet of development banks in a counter-cyclical fashion as discussed below.

83. Although current economic conditions heighten existing vulnerabilities, the system appears relatively sound and well regulated. To a large degree, this situation results from Government efforts implemented over more than a decade to enhance the regulatory framework and strengthen capacity to supervise the system. Non-performing loans increased to 3.8 percent in June 2009 which is affecting earnings. The deterioration of the credit portfolio and earnings is expected to continue in coming months, but the system’s capital and loan loss reserves appear ready to absorb these. The absorptive capacity, however, will differ across entities. Stress-tests conducted by the Comisión Nacional Bancaria y Valores (CNBV) suggest that the solvency ratio for the banking system would remain well above the minimum regulatory level of 8 percent.

Policy responses to the global financial crisis

84. For more than a decade, financial sector policy has featured prominently in Mexico’s development agenda with the dual objective of promoting stability and access. Overall the Government has supported these objectives through a multi-pronged strategy that encompasses improvements to the regulatory framework, a strengthening of institutions responsible for financial markets oversight, and pro-active market access policies through development finance institutions (DFIs). DFIs have undergone substantial improvements in their governance and institutional structure.

44 See Annex 5b for a more detailed discussion.

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85. In the wake of the global financial crisis, the Government has sustained the overall policy direction noted above but has moved quickly to mitigate risks exposed by the global crisis. More specifically, the Government has enacted regulatory changes and promoted a more active role by DFIs to prevent a sharp credit contraction by private financial institutions that would have aggravated the economic contraction. The most important regulatory reforms implemented in 2009 seek to address (i) the protection of consumers of financial services, (ii) the expansion of channels for the provision of financial services through banking agents, (iii) market transparency, and (iv) the transparency and impact of DFIs. Prudential regulations have also been strengthened.

Prior Actions in the Financial Sector Policy Area are:

• Enhancement of consumer protection, access to finance and market transparency by:

a. amending the Law Protecting Users of Financial Services to expand the regulatory and supervisory capacities of CONDUSEF as published in the Official Gazette on June 25, 2009; b. amending Article 46 Bis 1 of the Law of Credit Institutions to facilitate banking through agents as published in the Official Gazette on June 25, 2009; and c. amending fraction VI Bis of article 104 of the Capital Markets Law requiring issuers to provide information to the CNBV and to relevant stock exchanges about the issuer derivative positions and possible contingencies that said derivative positions imply for the relevant issuer’s financial situation as published in the Official Gazette on May 6,2009.

• Enhancement of the transparency and impact of state owned development financial institutions (DFIs) by amending the Credit Institutions Law as published in the Official Gazette on May 6, 2009 and establishing that:

a. DFIs shall publish monitoring indicators that evaluate the services provided by the relevant institution (art 31), and b. SHCP shall annually carry out and publish two evaluations(in which at least two academic institutions need to participate) of DFIs (art 55 Bis 2).

86. The global financial crisis brought to the fore the importance of fostering access to finance together with adequate consumer information. In this spirit, the Law Protecting and Defending Users of Financial Services was amended in June 2009. CONDUSEF will be responsible for (i) promoting an equal and fair relationship between financial institutions and its users, (ii) educating and informing the public on costs and quality of services provided by financial institutions, (iii) facilitating arbitration services between financial institutions and users, and (iv) issuing guidelines on marketing practices and financial contracts of credit institutions with the purpose of ensuring that consumers receive adequate information on their rights and responsibilities. The institution was already responsible for items (i) to (iii) above prior to 2008, but the lack of enforcement authorities severely constrained its effectiveness. The legal reform addresses these gaps by expanding CONDUSEF´s authorities to regulate, supervise and issue penalties. The institution will face the challenge of balancing the two attributions of

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arbitrage and regulation. It is currently developing an institutional strengthening plan to meet the greatly expanded set of responsibilities.

87. The Law on Credit Institutions was amended in June 2009 to facilitate the development of new and cost-effective channels to extend financial services to underserved market segments through the provision of banking agent services. The legal reforms will allow banking institutions to contract third parties (e.g., retail chains and retail stores) in order to provide services on behalf of the bank. These new channels could greatly expand the “outreach of banking institutions” which is currently limited. The bank will retain at all times the responsibility over the transactions conducted by the agents, minimizing risks to the population using these services. The CNBV has already issued regulations detailing the operational requirements for banking agent services, and at least nine banks have submitted a request to CNBV to provide these services. In addition, the CNBV plans to issue shortly a regulation that will allow banks to provide services through mobile phones considering operational and security controls.

88. The Securities Market Law (Article 104) was amended in May 2009 to address the lack of transparency concerning derivative instruments used by market issuers. Speculative derivative positions by several large Mexican corporations generated commercial paper defaults in October 2008 that nearly brought to a halt the commercial paper market. To restore market confidence, the reform to the Securities Markets Law requires market issuers to inform on their derivative positions, including payment conditions and the possible contingencies that such positions imply on the issuer’s financial position.

89. The CNBV has set up inter alia new provisioning requirements applicable to consumer credit by credit cards, supported in a prospective methodology compatible with the Basel II framework regarding expected losses.

90. The transparency and accountability of development banks and trust funds was improved through amendments to the Law of Credit Institutions in May 2009. Strengthening the accountability framework was important given the increased role played by development banks in the context of the global crisis. The three main changes are: (i) development trust funds will have to submit annual operational and financial plans to Congress through the Government as development banks currently do; (ii) development banks and development trust funds will have to publish indicators measuring their services to their target populations according to guidelines to be issued by the SHCP; and (iii) the SHCP will have to conduct and publish annually two independent evaluations on development banks or development trust funds that will include inter alia an assessment of how these institutions are meeting the access to finance objectives defined in their organic laws. The CNBV also issued a regulation that can allow, on a case by case basis, temporary increases in the credit concentration ratio of DFIs. While this could increase the risk exposure of DFIs, the risk is mitigated by the fact this is a temporary measure with a sunset clause that will have to be cleared by the CNBV and that the performance of these institutions is supervised by the CNBV as in the case of commercial banks. For the most part, the same prudential regulations apply to

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commercial and development banks (including capital requirements, internal controls, risk management, and valuation of financial products).

91. In parallel to the above regulatory measures, DFIs have expanded activities to sustain the flow of credit to the productive sector and other key areas and prevent a sharp credit crunch in light of deleveraging and increased risk aversion by private financial agents. These interventions have been market-friendly, meaning that they have sought to facilitate the functioning of private markets, not replace them. From September 2008 through June 2009, the credit portfolio supported (directly or indirectly through guarantees) by development banks had increased by 38% in real terms. DFI financing has supported the productive sector and trade finance, rural areas, infrastructure, and housing.

92. The Government intends to continue promoting the access to finance with stability agenda in the medium-term and several proposals are already underway. It is drafting proposals to establish a more agile and suitable framework for bank liquidation and is also collaborating with Congress on a proposal to establish a stronger regulatory framework for Sofoles and Sofomes in response to recent defaults by two Sofoles. While these institutions do not currently present a systematic risk, the authorities would like to prevent regulatory arbitrage and establish a more adequate regulatory framework under which they can expand. Further prudential changes area also expected over the coming one or two years in the context of the G-20 Framework Agreement. In addition, the Government is planning to develop a set of access to finance indicators to measure the impact of its policies. The financial sector agenda also envisages the continued institutional strengthening of DFIs, including the merger of Nafin and Bancomext.

Policy Area III: Labor Market 45

Labor market trends and recent developments

93. Historically, the Mexican labor market has been characterized by a low level of unemployment, yet persistently high rates of informality. Although the values of informal employment vary by source and definition, it has persistently represented over half of total employment. Linked to the slow growth of formal employment, two other prominent features of the Mexican labor market have been slow growth in labor productivity and in real wages. Total labor productivity, in terms of GDP per worker, declined throughout the 1980’s and remained stagnant until the middle of the nineties, presenting a sharp drop in 1995 due to the crisis. Average labor productivity, especially in manufacturing and agriculture, has grown since. Yet, the sustained improvement in these two sectors due to technological gains has been cancelled out to some extent by the poor performance in the services sector, which concentrates a significant proportion of the Mexican informal work force. The trends in real wages also show modest growth rates in recent years.

45 See Annex 5c for a more detailed discussion

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94. The global crisis has produced a sharp contraction Mexico’s GDP along with an increase in both unemployment and informality. Monthly data reveals a synchronized deterioration of labor market indicators, namely a decline in participation, a rise in unemployment commencing in the last quarter of 2008 and a fall in the number of workers enrolled in the Social Security. The unemployment rate reached 6.28 percent in August 2009, the highest figure since February 1996 in the aftermath of the Tequila crisis. The trends in net job creation have also been unfavorable with more than half a million jobs lost between June 2008 and June 2009. The deterioration in the labor market has also led to an important fall in real wages in some sectors.

Labor policies to confront the global crisis

95. Labor policies constitute one of the five key pillars of the ANFEFE to confront the global crisis that President Calderón announced in January 2009. The objectives of these policies are to improve the employability of the labor force, its wages and productivity, and protect labor incomes during the crisis. This operation supports the core active labor market policies implemented by the Government in the context of the ANFEFE that build on labor program reforms instituted during the current decade. The key policies supported by this Operation are: (i) improvements in the targeting and institutional set up of the Temporary Employment Program; and (ii) the expansion of the latter to reach a greater number of beneficiaries, including in urban areas.

Prior Action in the Labor Market Policy Area are:

• Strengthening and enhancement of active labor market policies by: a. improving the institutional setup of the Temporary Employment Program (PET) by including the Sub-secretariat of Employment and Labor Productivity in the technical committee that coordinates the PET and b. allowing the PET to be implemented in urban areas in addition to rural areas.

96. The Temporary Employment Program (PET) was originally launched in 1995 in response to the economic crisis of the times and operated in the rural area exclusively. Initially, the program was managed by the Ministry of Communications and Transport (SCT) and the Ministry of Social Development (SEDESOL). Subsequently, the Ministry of Environment and Natural Resources (SEMARNAT) and the Ministry of Agriculture and Rural Development (SAGARPA) also joined in program management. From 2001 on, the participation of the SAGARPA was gradually diminished and phased out in 2009, when the STPS was granted responsibility for its coordination to better integrate it with other labor market policies. The PET is currently administered and financed jointly by three ministries: Social Development (SEDESOL); SEMARNAT; and Transport and Communications (SCT). Broadly speaking, the reorganization of the PET around the coordination of the STPS will focus the program on its job creation goal. Under its coordination, PET resources will be directed to those areas where unemployment rates are higher. This will make the program a more complete mechanism of income compensation helping not only areas with problems of poverty or temporary, adverse weather conditions, but also localities with unemployment shocks.

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97. Along with the institutional changes, several other modifications were introduced in an effort to enhance the program’s effectiveness and targeting. The most important changes are (i) the PET’s extension to the urban areas, targeting those with the highest rates of unemployment; (ii) the participation of the SNE as an important channel to facilitate access and reach out to potential beneficiaries; (iii) the harmonization of information under one coordinated strategy; (iv) the increased frequency of results’ publications and coordination committee gatherings; and (v) the program’s systematic evaluation46. Following the administrative and institutional reforms, the Government increased spending on the PET by 157 percent during the period of January-June 2009 compared to the same period in 2008 to reach a larger number of beneficiaries.47 Further increases are planned for 2010. From January to September 2009, the number of PET beneficiaries already surpassed 549,000.

98. In addition to the PET, there are two other important active labor programs: (i) job networking and intermediation services; and (ii) the employment support program, consisting primarily of job training programs. Spending on all active labor programs was increased by 34 percent in the period January-June 2009 compared to the same period in 2008 in order to expand the number of beneficiaries. The number of individuals service by de program increased by 19 percent from January to August 2009 compared to the same period in 2008.

99. The Government has complemented the above with an expansion of passive labor market policies to sustain the standard of living of the unemployed. The two programs adopted are: (i) the coverage extension of health and maternity benefits for unemployed workers; and (ii) an increase in permissible withdrawals from mandatory retirement accounts for the unemployed. The former is a temporary measure that protects workers and their families during what can be expected to have been the worst period of the crisis (first and second quarters of 2009), and the latter is a permanent change with more substantive implication

100. While these measures offered a rapid response that has mitigated the negative impact of the global crisis, a broader and more comprehensive reconsideration of passive labor market policies may be necessary in the medium term.

101. Lastly, the Government has expressed its commitment to submit a proposal to reform the Federal Labor Law to Congress in the near future and to continue expanding active labor market programs in a selective manner, focusing on those that have received the strongest evaluations. Active labor market policies are not only important counter-cyclical measures but are also critical policy tools to facilitate the reallocation of labor from declining sectors to more productive economic sectors. Thus, the Government’s commitment to further expand them and build on the progress achieved with the recent reforms. Even though the scope of the current Federal Labor

46 See “Interventions and Improvements on the PET”, presentation by the STPS, August 2009. 47 According to figures from SHCP “Informes sobre la Situación Económica, las Finanzas y la Deuda Pública” second semester 2008 and 2009.

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Law is limited to a few areas, it moves in the right direction. Its eventual approval by Congress could prove the first step in a series of initiatives to modernize labor legislation in Mexico.

Policy Area IV: Trade Integration for Growth and Integration

Trends and recent developments

102. Mexico’s exports of goods and services increased from less than 17 percent of GDP in 1994 to 31 percent of GDP in 2000, facilitated by trade policy reforms, but started to lose dynamism in recent years having fallen to 28 percent of GDP in 2008. As a result, Mexico’s share in world trade has declined from 2.07 percent in the period 2000-2004 to 1.60 percent in 2006-2008.

103. Trade growth benefited from policy reforms that started with a deep unilateral trade reform process and accession to the GATT in the mid-eighties. This was followed by a policy of trade negotiations that began with the signing of the North American Free Trade Agreement (NAFTA). These have continued until now. So far, Mexico has concluded 12 preferential trade agreements with 44 countries, including the United States, the European Union, and Japan. Several rounds of unilateral tariff reductions also took place in 2002, 2004, and 2006. Changes were also introduced in customs procedures. These included inter alia (i) a special program for certified companies to accelerate the customs formalities of high-volume exports; (ii) an integrated computerized customs system to facilitate customs clearance for imports and exporters, enabling them to make their import and exports requests electronically; and (iii) training. Simplified administrative measures have been put in place for the Maquila sector through the Manufacturing and In-Bond Assembly Industry and Export Services Program (IMMEX).48

104. In addition to the slowdown in trade growth seen in recent years, the global financial crisis severely impacted Mexico's foreign trade. During 2008 exports increased by 7.6 percent due to the increase in oil prices during the first semester. Mexico's global exports and imports, however, fell around 30 percent during the first half of 2009. Oil exports decreased by about 55 percent and non-oil exports decreased by more than 22 percent during the same period. Mexico's exports are closely linked to the United States, representing 80 percent of total exports. Thus, the recovery of exports depends on the evolution of the crisis in the United States. In addition, exports to the United States are relatively concentrated in a few products categories. Three categories of

48 The IMMEX refers to the Decree on the Promotion of the Manufacturing and In-Bond Assembly (Maquiladora) Industry and Export Services. The IMMEX provides for the deferment of tariff payments for temporary import of raw materials, parts and components. The tariff is not paid as long as the inputs are incorporated into a product for export. Companies conducting operations with IMMEX can register through a digital system.

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the Harmonized Tariff System (HTS) represent 59 percent of Mexico exports to the United States.49

Trade Policy Measures in response to the loss in export dynamism and the global crisis

105. Despite the trade policy reforms noted above, the Government of Mexico had identified gaps in its trading regime and opportunities to further reduce trading costs. A study conducted by the Ministry of Economy identified inconsistencies in Mexico's tariff structure. According to this study, higher tariffs were applied to inputs than to final products resulting in negative effective protection, particularly when producers in countries with which Mexico has preferential agreements may import these inputs at lower rates and use them to produce goods that were subsequently exported to Mexico. The antitrust authorities also provided a critical assessment of Mexico’s trade regime in an opinion in 2008, highlighting that the tariff structure discriminated between importers and created distortions that limited the ability of domestic producers to compete with foreign producers. The effective elimination of these distortions requires that all producers gain access to international markets on a non-discriminatory basis. The antitrust authorities also highlighted the need to address existing non-tariff constraints, primarily related to customs service providers.

106. To address these issues and further Mexico’s trade integration, a comprehensive tariff reform and staged reduction of the MFN tariffs on manufactured imports over a five year period (2009-2013) was adopted in December 2008. These measures complement other labor and financial sector reforms that seek to build a more competitive productive base and generate the conditions for sustainable growth and will also decrease costs to consumers with a positive social impact.

The Prior Action in the Trade Policy Area is:

• Reducing the Most Favored Nation tariffs on manufactured imports and increasing the number of duty-free tariff lines in a staged manner over a five year period, starting January 1st 2009 in order to enhance trade, competitiveness and simplification of the external trade tariff structure by amending the Tariff Law for General taxes on Imports and Exports as per Decree published in the Official Gazette on December 24, 2008.

107. The comprehensive reform rationalizes the tariff structure, reduces distortions, and trade costs. The reform would lower tariff rates for all non-agricultural products over a five year period through January 1st, 2013. The reduction is expected to lower the average MFN tariff rates for industrial products from 10.4 percent to 4.3 percent in 2013. The reform will simplify the tariff structure from thirteen different levels to six. This means that the reform will decrease the tariff dispersion as well as tariff

49 These categories are: (i) electrical machinery and equipment and parts thereof; sound recorders and reproducers, television recorders and reproducers, parts and accessories (24.7 percent); (ii) mineral fuels, mineral oils and products of their distillation; bituminous substances; mineral waxes (19.7 percent); and (iii) vehicles, other than railway or tramway rolling stock, and parts and accessories thereof (14.9 percent).

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escalation, and reduce inconsistencies in the tariff structure by cutting the negative effective protection that currently prevails for some goods. As a result, special preferential import regimes will lose their relevancy.

108. Overall, the reform is expected to lead to welfare gains. The enacted trade reform will reduce trade diversion, create greater regulatory certainty and cut the operational costs of the current users of special import regimes. Due to the high administrative costs of accessing the special import regimes, larger companies had been the main beneficiaries of these programs. The tariff reduction makes the special imports regimes less attractive (or relevant) and the general import regime more accessible to all producers. Hence, the tariff reform is expected to widen access for smaller enterprises to more efficient inputs on a non-discriminatory basis increasing their competitiveness. An import surge is not likely to occur, particularly in the context of the current collapse in world trade; however, certain industries probably will face more competition from a large number of suppliers—in particular, from the Asia-Pacific region. The activities that could be negatively affected are textiles, plastics, metal products, leather products, paper, printing, chemicals, wood, and oil and coal related industries. Several of these industries had experienced a fall in their participation in total manufacturing employment and value added prior to the crisis.

109. The reform will also reduce costs to consumers. A 2004 study found that the Mexican tariff structure imposed welfare losses of US$2 billion for its citizens. The Government is implementing other reforms with the active support of the Bank that seek to further reduce trade costs, the most important of which is the program for strengthening customs administration. In addition, it is assessing possible options to facilitate greater competition in the provision of customs related services.

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Box 3. Summary of Prior Actions and Outcome Indicators

Policy Area 1: Fiscal Policy and Public Expenditure Management

Objective: (i) Meet the country’s social and public investment needs to enhance the creation of human and physical capital in a sustained way; and (ii) strengthen the ability of the Government to mitigate the impact of economic recessions on social and economic progress achieved

Prior actions:

Implementation of countercyclical fiscal stimulus measures during the first semester of 2009 as demonstrated by (i) an increase, in real terms, of current spending by 5.4 percent and (ii) an increase, in real terms, of public sector induced physical capital investment spending by 27.7 percent compared to the same period of the previous year.

Submission to Congress of an Economic Program for 2010 outlining a multiannual fiscal policy strategy including: (i) the creation of new taxes and modification of existing taxes to enhance non-oil revenue; and (ii) a temporary deficit and the use of non-recurrent revenues to compensate for a temporary, cyclical shortfall in public sector revenue.

Issuance of a General Governmental Accounting Law to harmonize accounting standards among the federal, state and municipal levels of the executive branch of government as published in the Official Gazette on December 31, 2008.

Outcome Indicators*

Public Sector Borrowing Requirements

Federal Public Sector Programmable Expenditure

Non-oil tax revenue

Adoption of a harmonized budget classification system at the federal and state government levels

Policy Area 2 Financial sector policies

Objective: Foster (i) stability of the financial system and (ii) access to finance to promote growth and improvements in households’ living standards

Prior Actions:

Enhancement of consumer protection, access to finance and market transparency by (a) amending the Law Protecting Users of Financial Services to expand the regulatory and supervisory capacities of CONDUSEF as published in the Official Gazette on June 25, 2009; (b) amending Article 46 Bis 1 of the Law of Credit Institutions to facilitate banking through agents as published in the Official Gazette on June 25, 2009; and (c) amending fraction VI Bis of article 104 of the Capital Markets Law requiring issuers to provide information to the CNBV and to relevant stock exchanges about the issuer derivative positions and possible contingencies that said derivative positions imply for the relevant issuer’s financial situation as published in the Official Gazette on May 6,2009. Enhancement of the transparency and impact of state owned development financial institutions (DFIs) by amending the Credit Institutions Law as published in the Official Gazette on May 6, 2009 and establishing that: a) DFIs shall publish monitoring indicators that evaluate the services provided by the relevant institution (art 31), and b) SHCP shall annually carry out and publish two evaluations(in which at least two academic institutions need to participate) of DFIs (art 55 Bis 2).

Outcome Indicators*

Quality of information provided by financial intermediaries to users of credit cards, checking accounts and mortgages loans Number of total outlets that provide banking services Two independent evaluations on strategic programs of development banks conducted Publication of impact indicators of development Banks in reaching the targeted population

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Box 3. Summary of Prior Actions and Outcome Indicators

Policy Area 3: Labor policies

Objective: (i) Improve employability of the labor force; (ii) Increase labor productivity and wages and (iii) Protect labor incomes during recessions

Prior action:

Strengthening and enhancement of active labor market policies by (a) improving the institutional setup of the Temporary Employment Program (PET) by including the Sub-secretariat of Employment and Labor Productivity in the technical committee that coordinates the PET and (b) allowing the PET to be implemented in urban areas in addition to rural areas.

Outcome Indicators*

Number of beneficiaries hired through PET Amount of worker shifts hired by PET

Policy Area 4: Trade policies

Objective: Deepen integration into the world economy; reduce trade costs; increase transparency and legal certainty in trade regulations

Prior action:

Reducing the Most Favored Nation tariffs on manufactured imports and increasing the number of duty-free tariff lines in a staged manner over a five year period, starting January 1st 2009 in order to enhance trade, competitiveness and simplification of the external trade tariff structure by amending the Tariff Law for General taxes on Imports and Exports as per Decree published in the Official Gazette on December 24, 2008.

Outcome Indicators*

Average MFN tariff rates for manufacturing imports Share of tariff lines out of total manufactured product lines that can be imported duty free

*See Annex 2 for more details

VI. OPERATION IMPLEMENTATION

110. OP 8.60 (Development Policy Lending) mandates the Bank to determine whether policies supported by the operation are likely to cause significant effects on the country’s environment, forests and other natural resources as well as assess the poverty and social impact. The policies supported by the proposed DPL are expected to have a positive impact on poverty reduction and a negligible, or even somewhat beneficial, impact on the environment.

Poverty and Social Impacts

111. The program is expected to have a positive poverty and social impact on the poor and vulnerable groups. A poverty and distribution analysis carried out by Bank staff (Annex 6) assesses in some detail the poverty and social impacts of policies included in the fiscal, labor market and trade policy areas. These findings are complemented with an additional qualitative assessment of the impacts of financial sector policies. Further work on a full Poverty and Social Impact Assessment (PSIA) of the policies will be carried out by Bank staff together with government counterparts during program implementation.

112. After a decade of continuous decline, the most recent official poverty figures show that Mexico has experienced an important increase in its poverty indicators between 2006 and 2008. Extreme poverty (pobreza alimentaria) increased from 13.8 to

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18.2 percent and measures of moderate poverty (pobreza de capacidades and pobreza patrimonial) rose from 20.7 and 42.6 percent, respectively, to 25.1 and 47.4 percent.

113. The increase in poverty indicators is attributed to the increase in food prices during 2007 and early 2008 as the indicators do not yet register the impact of the current crisis. The severe contraction of economic activity in 2009 is expected to produce a further upward impact on poverty in Mexico even though the Government developed over the past decade a well-known set of policies and programs to confront and mitigate the impacts of the crisis on poverty. For example, when the global food crisis was reflected in a rapid increase of food prices in Mexico, the Government was able to mitigate the impact on the poor by rapidly increasing the amount of conditional cash transfers.

114. The main findings with respect to the specific policies supported are:

Fiscal Policies

115. An evaluation of the distributive impact of the budget proposal by the SHCP shows a very progressive impact in terms of the absolute incidence on households in the bottom three deciles of the income distribution. This occurs as the introduction of new taxes and changes in existing tax rates, including the proposed “contribution to reduce poverty” on consumption, is more than compensated by an allocation of additional budget resources to expand the conditional cash transfers under Oportunidades and other social programs benefitting the poor. This expansion will cover both an increase in the number of beneficiaries and an increase in the level of transfers to existing beneficiaries that more than offsets additional tax payments. Households in the bottom three deciles of the income distribution can on average expect an additional income transfer of 12,577 pesos against additional tax payment of 1,304 pesos per family. These estimates are conservative since they assume that all the new tax is passed through to consumers. In addition, consumers in the bottom of the distribution are less likely to purchase goods from formal retailers.

116. There is a need to carry out a more complete distributional impact assessment of the fiscal program as the final relative and absolute incidence of the whole package will depend on adding all the tax and transfer effects in each social group.

Financial Sector Policies

117. Financial sector policies supported by this operation are expected to have a positive social impact. In particular, the approval of a regulatory framework for the provision of banking services through agents will permit the expansion of basic financial services to lower income groups of the population through new cost-effective channels, helping to narrow the current wide gap. The enhancement of the regulatory and supervisory capacities of CONDUSEF should lead to greater transparency in financial contracts and better informed users of financial services, particularly benefitting lower income households and micro and small entrepreneurs. The support provided by DFIs to facilitate the continued flow of credit to the productive sector should contribute to

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employment preservation in the short term. As the macroeconomic environment rebounds, the facilitation of credit flow to underserved markets inter alia to SMEs should facilitate growth and employment generation. SHF’s emphasis on credit provision to households earning less than 6 minimum wages is also helping to enhance the standards of living of lower to middle income households

Labor Market Policies

118. Temporary employment programs are considered an appropriate mechanism for dealing with cyclical downturns in the labor market as in the current crisis. These programs provide an income support for those who lost their job and, given the self-targeting mechanism—usually at a pay below minimum or nearly minimum wages—focus on those most in need of finding an income source. Data to June 2009 indicates that nearly half of those that became unemployed were non-salaried (256,000) and thus the PET is a particularly appropriate instrument for this group.

119. Regarding the expansion of SNE programs, in particular the training program, the most recent evaluation report by CONEVAL confirmed the favorable findings of previous studies. These indicated that the training programs had a positive effect on the probability of finding employment, although no significant, or ambiguous, effect on salaries.50 Several evaluations usually find a larger positive impact among women and those with less formal education. Given the fact that women and those with less formal education have, on average, lower earnings it can be said that these training programs have progressive impacts that benefit more to those in the bottom of the earnings distribution.

Trade Integration Policies

120. As noted earlier, the tariff reform is expected to lead to positive effects through cost reductions to consumers. At the productive level, the sectors that will benefit from the tariff reforms are mainly the agricultural, construction, and services sectors that generate 85.7 percent of total employment. Within these, SMEs are expected to benefit more in relative terms given that it had been relatively more costly for them to access the special imports regimes. Regarding the manufacturing sector, the authorities expect that the potentially affected companies comprise 14.3 percent of total employment51. The activities that could be negatively affected are textiles industries, plastics, metal products, leather products, paper, printing and related industries, chemicals, wood industry, and oil and coal related industries. Several of these industries have experienced a fall in their participation in total manufacturing employment and value added prior to the crisis. The recent expansion of active labor market programs (inter alia retraining programs) supported by the third pillar of this operation will provide assistance to workers that might be adversely impacted by the tariff reform.

50 See, among others, Revenga, Tyboud and Tan (1992), Wodon and Minowa (1999), Delajara et al (2007). 51 Information provided by the Ministry of Economy.

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Environmental Aspects

121. The proposed operation is expected to have a negligible or even somewhat beneficial environmental impact. The government’s fiscal program is consistent with environmental sustainability. Environment sustainability is one of the key pillars of Mexico’s 2007-2012 NDP that seeks to mainstream environmental sustainability principles in sectoral policies and economic development. Despite the economic crisis, the Government has explicitly maintained its commitment to environmental sustainability and has continued to develop and implement public policies that protect the environment, including the development of infrastructure policies that combat climate change and green house gases. These efforts are being supported by the Bank with a series of environmental DPLs (Environmental Sustainability DPL and the Green Growth DPL)

122. The enacted tariff reform is expected to have a negligible or even somewhat beneficial environmental impact. First, the reform does not apply to agricultural products. Second, tariffs for environmental goods52 are lowered and the import of these will no longer require following cumbersome procedures of multiple trade agreements. Third, Mexico’s environmental regulations are in agreement with the Banks’ overall environmental safeguards and these regulations will continue to apply to imports as well as for the granting and enforcement of construction and business operation permits. Moreover, the simplification of trade procedures will now facilitate their enforcement. Improvements in the systems of the customs administration agency and its interfaces with other public agencies, including SEMARNAT, will facilitate the enforcement of these regulations.

Implementation, Monitoring and Evaluation

123. Implementation of the loan will require close coordination among Government agencies and the Bank. The SHCP constitutes the primary counterpart, and the CNBV, CONDUSEF, the STPS, and the Ministry of Economy (SE) will also be involved in program implementation. As the Bank’s primary counterpart, the SHCP will be responsible for coordinating information reporting on the program’s monitoring indicators, and the Bank team will also maintain a close dialogue with Government counterparts. The matrix of proposed indicators is presented in Annex 2. All the indicators have been discussed with the Government authorities and agreed on during program appraisal.

124. Since the proposed DPL is part of an ongoing programmatic engagement in the four policies areas (fiscal and public expenditure management, financial sector, labor market policies, and trade integration and facilitation), the Bank will have the

52 The environmental goods and services industry consists of activities which produce goods and services to measure, prevent, limit, minimize or correct environmental damage to water, air and soil, as well as problems related to waste, noise and eco systems. This includes cleaner technologies, products and services that reduce environmental risk and minimize pollution and resource use (OECD, Policy Brief, September 2005). Environmental goods are classified into four categories: pollution management, cleaner technologies and products, resource management, and environmentally preferable products.

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opportunity to monitor the reform impact beyond 2010. This will be important given that in many cases the target indicators for 2010 cannot be reflective of the full impact of the reform. The proposed technical assistance in the area of access to finance, investment operations underway and proposed new operations with development banks, as well as future FSAPs Updates will provide an opportunity to oversee the full fledge impact of these reforms. Two critical Technical Assistance loans were approved last year—one for results based management and budgeting, and another for customs administration—that will provide the basis for monitoring implementation in other key areas of the proposed operation over the medium-term. In addition, there is a non-lending technical assistance underway in the area of labor market policy. Furthermore, a full PSIA analysis of the policies adopted by the Mexican Government to cope with the crisis will be produced by Bank staff in calendar year 2010.

Fiduciary Aspects

125. In general, public financial management (PFM) systems in the Mexican federal administration are adequate for DPL lending, as documented in the 2003 Country Financial Accountability Assessment (CFAA), 2007 Country Procurement Assessment Report (CPAR), and other analytical work. The DPL would fund the Federal Expenditure Budget (PEF) and, accordingly, be subject to provisions of the annual PEF Law, the Federal Budget and Fiscal Responsibility Law, the Government Accounting Law, the Manual of Budget Procedures, and others. This set of legal and regulatory arrangements, together with their implementation systems, provides for sound budget formulation, execution and control arrangements. Other internal control aspects are ruled by the Federal Public Administration Internal Control Standards. As for external oversight, the Federal Supreme Audit Institution executes regularly a number of performance, financial and compliance audits on Government programs, and their results are made public in the annual audit report on the Federal Public Accounts. Good systems are in place for follow-up to internal and external audit findings. There is room for improvement in some PFM areas, such as certain procurement and accounting practices that are not completely up to international standards, but there are plans underway –which the Bank is supporting- to move in that direction.

Disbursements and Auditing

126. The flow-of-fund arrangements are those customarily observed in DPLs for Mexico, as per long-standing agreements with the Government. The SHCP has informed the World Bank that BANSEFI will be the financial agent of the Borrower with regard to the DPL. Under this arrangement, upon effectiveness the Bank would make the single tranche disbursement to a designated account in US Dollars of BANSEFI,53 for subsequent credit to an account of the National Treasury (SHCP/Tesorería de la Federación, or TESOFE) used for general budget expenditures. The funds would thus become available for financing of budget expenditures through the PFM systems

53 The use of a financial agent and dedicated account is a local standard procedure established by the Government of Mexico for their control purposes, not an additional arrangement requested by the Bank.

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mentioned in the previous paragraph. If requested by the Bank, the SHCP would provide the Bank with a written confirmation of the described transaction.

127. Based on the assessment of the PFM and banking environment, no additional fiduciary arrangements are deemed necessary for the DPL. The review of external audit reports and the extensive flow-of-fund experience between the Bank and BANSEFI reveal that there is no evidence that the banking control environment into which the DPL proceeds would flow is other than adequate.

Risks and Risk Mitigation

128. A key risk to this operation is a substantial modification by Congress to the economic package and budget law proposed by the administration. Debates within Congress are progressing; however the final budget that is ultimately approved could represent an unexpected worsening of the fiscal position in 2010. Perhaps more importantly, structural medium-term revenue enhancing measures might not be approved. Mitigating factors include the Government’s extensive negotiation and public dissemination efforts, as well as the broadly recognized need for a reduction in dependence on volatile and uncertain oil revenue and the possibility that the executive may implement alternative policies under its control if required.

129. Another risk is the possibility of a weak recovery from the current economic downturn including a “double dip” recession in the United States, Mexico’s main trading partner, that could lead to a second year of subpar economic and public sector revenue performance. Fiscal outcomes would be jeopardized, and it may be difficult for the Government to maintain expenditure levels for key social and infrastructure programs. A mitigating factor is that Mexico’s fiscal track record has assured good access to financial markets with a credit rating still two notches above investment grade. There should be adequate access to credit to borrow through a second downturn, so long as medium revenue reform measures are approved by Congress. The Government has confirmed that the policies and institutions supported by the DPL are given priority in its economic program.

130. The increased activity of development banks at times of economic distress and in riskier market segments is likely to lead to an increase in NPLs and may negatively affect their earnings. This risk and its potential impact on the institutions is mitigated by several factors. First, the governance and institutional structure of development banks has significantly improved over the past decade. Second, all development banks have a capital adequacy ratio well-above the regulatory minimum of 8 percent, which provides them with a certain buffer. Third, additional guarantee programs have been supported by supplementary counter-guarantees from the Government, so that there is a transparent and up-front recognition of the extra expected costs of these programs. Fourth, high credit risks to the corporate sector have been overcollateralized or structured products have been devised to minimize the potential losses to the institutions. Fifth, the CNBV is monitoring closely the performance of development banks as part of their supervisory duties.

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131. Efforts to improve the flow of credit through the financial system could be overcome by negative developments, such as a substantially weaker economic recovery than currently anticipated. The financial system remains sound; however, a second round of negative economic development inevitably could lead to additional increases in non-performing loans and limited scope for banks to extend credit. Mitigating factors include the strong initial condition of the financial system, the scope for additional financial intermediation by the country’s development banks, the strong credibility in the conduction of monetary policy by the country’s central bank, as well as stress tests conducted regularly by the CNBV.

132. Labor market conditions could continue to deteriorate even during an incipient recovery. The Government may need to expand or enhance the measures supported in the proposed DPL in order to mitigate the social and economic impact of such deterioration. These actions could confront fiscal constraints—particularly in the event of a “double dip” recession. A mitigating factor is the improved targeting, evaluation and coordination in the implementation of Government’s social programs as well as the progress in public expenditure management to guide the reallocation of public expenditure.

133. The Government may decide to delay implementation of the next stage of tariff reductions, due to political pressures. The initial measures of the decree lay out a clear time table; however, a second decree could be issued to delay implementation. The Government’s commitment appears strong and it plans to continue informing the public and industry of the benefits of the reform to mitigate pressures.

134. There could be institutional impediments to customs simplification efforts. Effective results will depend upon improved function of the customs agency. A mitigating factor is that the customs agency is strongly committed to these reform efforts, and the Bank’s supervision of a technical assistance loan will provide a partner for institutional development.

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VII. ANNEXES

ANNEX 1. LETTER OF DEVELOPMENT POLICY

Sr. Robert B. Zoellick. P residente. Banco Mu ndi .. 1

E.nmado Se ~or Zoe lliCk:

SECRETARIA DE HACIENDA Y CREDITO PU BLICO

SUb!OQCHll;lfi ~ doo H~ci.md;J V CredilO Publico

Olleio NO. 102· B·173

Mbico D F 20 de C>CIut)re d e 2009

EI horizonle mundi.1 h. c"mbi.do radicalmen!e. La r""""iOn glC>ba1 que com enz,; a medi..oo~ de 200S y que SEt recrudecio a r",~Ie$ de eoe afio, ad~u"i 6 proporcione$ lnusitada$ 'i sin pt&e@dMt8 en la5 Uitrmas $ieloe deeadM d~ la hlstoria murlClial. La eeoneml .. mexiCSIli ~e h~ v~to afeclada con p~r1rcul.ar gravedad pOI Ia corjullCiOn de val'lOS I.ctore~ oo.e~os. En ",Ie con!exto. y en .. I marCO de l~ prepara<:iOn de un prestamo del sanco Mundla l M apoyo 311 Programo de PoI iti""s Ecooomicas en Respuesla a 13 Cnsis Global, ~ traves de est~ Cana de PClIillc:a de Dtt,arroAo describo Ia. condicio nes de 18 e col'lOrrl i .. mexlcana , la s acaones ma.~ [etev"nte~ de po liti<:<! &COr16n1 ic(I; que I~ Admini$tr""iOn del Pretirdente felipe C~1der6n h3 ~.~do ~ cabo, asl como et pmgrllma !!{;oo/:rmiGO 2010 que ha puesto a C(ln$lderac i¢n del (;ongreso de Iii UniOn,

POf $U f"I rte, 13 ".13cilm te c:nica y frnanciera de Mexico con " I B~n<;O Mundiorl en et present e contexto e:conOmi ~o global 5e 11 ~ intemif"tcadQ. E$ ~ r;le.tile<rr.e qve et Gobiemo de M~xicQ mant","," una "(/enda aGllva de d Ialog<> e ,nte"",mbio de experie<tciu asi como de a"'.tencia [,k nica con eI BaflCO Mundi;d en varia" "" las ,"us "."ncl3Ie. det mo.co iMlitucron . 1 QUe poflnll"n 13 aplicaci6!1 de pQi i tic ~ s con!racl~licag asl como de pot ibca~ macr<>ecoo6mica. que con!nbuyan a 18 rerope.adOn y e l creciml"nto soelen>bie de 18 e conom la me xicana. En particu lar. lu . ",a . de potHica ... Ieccionada . e .tlrn ",Iacioruda. con la ~itlca f .. ca l y la Sil<:$ltO n delga,to peblico , et sistema rlnancie ro. la poiibca laboral y.1 comercio .x ~erior D;>da I;ir coy""lu •• actua l. sotici!amos aho ra apuntalar lat aedorres que estamO$ llellando a cabo en es!a. lI.ea. con apoyo fi""ncie.o de! Banco M""diat.

Ambiente macroeconomico

La profunda caida de l com"r"io ""temacronat y la foorte caid. en I. produceiOn ind"'lrial &n Il>:I E",ados UniOo .... tradujo en "" abtuplo descen.o de 18 acti'vidad productillll de Is industria me,icon. q<.>e <:$[a fu e<1e me nte integradll con "I sector manufaclur!fo de ~ E8taoos Unid~ ,

Dada el gran pno ~ue i iene el eomercio eX!\lrior y la producciOn Indu~!ri~ 1 en la ecooomi ~ m" .. cana , la contracciOn global .e .efleJo en un mayor de.censo de l PIS en nuestiO pals d~rant" 10. d05 pOme ros l,imeSiles ""@steaM

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SECRETARIA D E HACIENDA Y CRIO.D ITD PUeLICD

Sub """,.elarlS ce Haclenoa y Cr~drto PlJblico

OfIcle No 102-B·173

La ",;'is iruem.cioJlal ha I .... do la mb,e" " una menOf di~pon,bilidad d@ financtaml8nlo a niv'" global. EI aumanlO en la dema flda de fin'HlCIilrr!leJlIQ de 10,. paise. induslrializados, las perdida. de ""'p'I~1 de' In ''''I ilucione'' r",anc~ra5 a 5i com" I .. """5 ion a 13 rflgu lac,on finar.e.era que e~l;;

"",,,,nendo alle<>ed Of del mundo 11"" ... ~n a cordie"""," men<>. favorable. de fin.nci .. millnlo durant'" 10$ prO"''''''" anos

M~)(jco enlrenl. "de mas Iii de'clini>cl6n de la p,oducci6f\ p8t.oIo,a d utant.o 100 Ullimoo cualro a~O$, 10 ~ue re!ull a neg"Iivo dad a la alia pan icipaci6n de 10$ ingreses ~r hidroca,buro" en la" linanza. pUbliCIOs de M,;'i c"

Debide " eslas fadores "dvs'ws, se P'~ que dur"nl .. 2009 .. I PIB en Mllxico ~iI'5Ia 6_8 POr cienl"_ Sin embaro<', .., enticipa un ",ecim~nle secue ncral positivo durante fa .egunda mrtad de 2009 En ildiciOn iI " nil eSI~biliIiO(;iW Y fl'CUpefllClOn qlle h;r ~omen~ado a oo$erv.'$e en l;! econom;" m"ndiill, oonto mo s Con varies $1$menIOS que contribuidJi 3 13 '&ruf>eraciOn desplJl!-& de I~ cm;~ lOIS efecl" s de 18 aplicaCl6n de poIltica~ oontracicftca' , e n los I renles li.cal y monetari<l , as; como 3 lrav08S d~ la banea d~ de sarrollo y del ;"' pulse a I" ",fra ... lruclura y I •• ""eooa han . 1d<> imPOrtantes . A e llQ se suman, ,om" lortalezas, la estabilidad de predo., un ,;;stema finaneiero fueriemenle c:apilalirndo y s""""nt~ a si eomo un t,po de camillo mlh eompetlliv"

RelO' d$ la Polilica Fiscal

Una de la. ConseCuenclU negaliva~ de III en"" inlernaciona l ha ,ldo que e n e l caso d e Mex ico he Ile.ado II una dismin uci6JI rapida y pronunc:iada de sus irtgr .. s,," ~blicos un finanzas pUt> icas del pal s &e han vislO prol"ndamente aleclad.s por 10 connuencia de la ca;d. en la .cti >'idad e c0n6mlCa, d erivad8 de 18 cr;SlS inlemaclOJlal, y de Ia menor plalaforma de produ.cci6n y preaos de pelr~eo Eslos lactore. han l!evade a I. mayor c;oida en lo~ ingft!-$O~ p<!lrolaros y tributa,ies no petrOieros registr3d.a en cu~ndo nteflOS IQS OltlmO$ Ireinta al\0$ _

A pe •• r de eilO, .1 uso de ing '''''''' nQ recurrente . como I. c"bertur. del petrO L"" Y 1o; aho"", e n 10$ fondos d~ estaDiliza c:i6n ha n permilido prolege< eI 9aslo duranle 2000 Con eUo, .e manli...,e eI impulso conlraclciicc bliridado por "'" f,n anz •• pub ica~ en el p rflnnte momenlO de d .. bi~dacr e<:oOOmlCa

Sin emba r{jO las fll't anZ3S pUbhc8S del ps is enlrerltan un problema estructural 8soci;loo ~ la meoor prcdUGCl6n d e pelr6lee que requiere de .61uc",ne5 ",medi. la5 iguaimenle e.lruclurales En p .. r!icular , Ia prop ....... la fiscal que ef Preoidente Ca ide<6n ha pr@senlado .. cons id~,acjl>n d'" Congreso de 111 UnlOn conduclr~ a un ~i u$te ordet1ildo de Iii. Jinatllas ~blic;o., con objete de iorta"'''''M' en el cOfto y medi~no plazo As;' e l programa ~eon6m;co para eI a~" 2010 esl~blecl",1 bases mas (,rme. de ;.,gre, os qu e s u.l iluye n " 10. menores recu rso. pelro1e,o" _ I~ vez que e.timula'~ eI crec;"'ient", la crucl6n de ampleos ~, por s upoeslO , .. 1 abaUmien!o de la pobl"eza.

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SECRETAR IA DE HA.CIENDA V CRf: DITO PUBLICO

Sut>secrela"a do l-IaclOnda y C redltO P~ t>llco

Oflcio No 102_8_173

M~xiC(l D I' 10 d" OCIut>,,, de 2009

E$ indisF"'nsabie 1I".a, " cabo una relorm" flsc at q"'" nos !'e,m"" hace, 1,,,n1" a la coyunwrlI ado",,<I , at mismo ti....,.,po """ 005 ayude a cornp&nsar 13 dismil>wci6n eo 13 ,,,nla P"\role,a debido ala m" no, p!'odl.'Ca6n de hidroearburos, EI obi"l<oO es Iograr 13 combin ""Kin 6pl lma de rTlI!didas que pr".erve 31 m".imo po$ible " , "npol50 a la economi a y at empleo, "on poner en dud" la vi~biidad (je lu (onanza~ pUbliC3~ en el medi~no p l~lCI E~lo lr~ lmo ~ !r~v~' de ~s!ablecer un e."""ma lisca l s6lido y " ficrenle, mMO$ wlner3ble <II ta V(l lalilidad de 10. ingre.o. pelro le,o. y donde t l gaS!O se l eoe a cabo de forma tran.parente, efieienlt y 5e " signt a las gnmdes priOfid,Hj\!S nacion i l@s D@bioo iii .. 10, I~ p ropues1~ 0.. PilQuele econOmlco p~ r .. 2010 leOOr, 1m .igwente. componenle.

I, Un mayor endeudamien!o, reClK1iendo a un deflCtt fiscal l....,.,po,al y moderado vrncul ado al CICio de .. e<oonomia. EMe . e complemenl. con rngre.os flO rewrrenles y uSc de ahO<TC S

II. Un aumenlo en I" recaudaci6<1 P"nn~n.nle de ir>gresos no pelfoleros ~ Iraves de mocj,frCBcrones ~I m~rcQ Iribular", ~ una fiscalizaci6<1 mao .,Iic te nle,

Par" hac .. r Ir""le 3 13 ea ;da !,anSOlon3 de ingresos pub'oos se r&cuffi,a a 00 cllilk il fiscal lempo<al y mod<!f"do y se empluran ingresos no re<ourrMI"". En lanto que para hacer !romle a Ia caida de la produccr6<1 palrolera u propene un eol ....... o de ';uOl ~ y conl .. nci6n d.t 9" $10 pUblico acompar'iado de m ayor <tIiciencla , lransparencra '/ refldra¢n de r;uenlas. asl como aum""lar I. r8C3udxrOn de .o9re500 Inbulano . f10 ~rC>lero •.

La Agenda Estru clural

AnWn de 13 wlneralJ.j\jdad estf\lClur;of de las fm;lnza • .,ubficas, \X'r la dep<!nd&ncia de k>. vo@~". precros del pelrOleo y de la dedinan!e prodtJccil)n de crudo. eS neeesa,;o lamb"" leva, a cat>o acciones qlle 00. pennitan acete'a' el crecimrenlo de III e.:onomia me~tc<lna

Po< ello. nO$ proponemos establecer una gran a~enda integral y un n.Jmbo claro rnadianl .. una poIillCa eSir<tl&glca que nos permlla ..,cremenlar la compelltlllldad de Ia ecooomia mexican .. , Ifenar el crecrmienlo de '" pObreu y pro-veer a 10001 los """ ;",,nos de oportunrdades pa ra vi";' ""''''': !Ie

I,ala de proponer 00 cun.o de aGerOo que .obrepase 10 ~OYUlllural y que, adem~. de propicia, Ia ,eactioacj6n de Is e.onomi • • eSlablezca ObjellVOS ambrcioso. de medlarlO y largo plazo

Las reformas pt"Ojl ueslas en el ambrlo CIe 13 compellliVidaQ son adem~. complemenl...-;a. a Ia reforma fiscal : aun con relorm a. a lao'" de Ia c:ompelllividod dil iolmenle aument3r3 el crecim~nlo

y la ifwersiOn en ~u.enci~ de f.,anus publo"" o sonas, Y oi bOen la ",,"en;birrd ad de las r.naflZa5 o.>blien e. condiei';n necesana para un cracimienlO aeel .. flIdo, 00 e •• ufldeme

- 46 -

SECRET .... RIA DE H .... CIEND .... Y CR~DITO PU8LICO

Subsecreta,ia de Hacienda y C"xllto ",,,bhco

Ofi"", No. 102_9·173

M<!~ICO 0 F 20 de <>club,e de 2009

-. f~\ • • • • ... " . .. -

NueSl ras lasas de crecmie!lto econOmlco y de lIeneraC;(m de empleos ~oo insufic..ienles debido a una baja competilividad. Po, @1 1o. ""'be pOorlz" .. e Un3 ... end~ de accione& en el ambito uooomieo ()!Jl' lIeve~ a un mayor credmie/Uo: tlaj) eI cnt8l10 de que II gobie roo puede contribulr mas facilitando I~ I'tCtrvKlad de l r" 'la de 10. act<>re5 ..cOOOmICOS a "",06$ de "" marco legal. iXlmin istrat .. o y r"9"olooo .decuado. que medi;)nte eI gn1¢ di~I~. P~r~ elk>, ula net~ulio avamar en Walro Irente. clave que oon,

Haoer q"" el me.-.;aoo de los InS""'05 fundone """ior ~ que d .. ahi s .. de<ive una may,,"" COI\""lpetilMdad. parlicu larmente ~oo respec:a a las . .. Iaciooes Iabonles ... 1 merCildo -de las lelecomun"'ilcKlfles, cl Kc;:Ior de la energi". el sistema fll1al'lCiero en su conjuntO y 18 iINe .. iOn en ;nl,,,,, ."uetura fMJblica

2 Mejorar el marco irl5I11l>C;onal que dete.-m;';a Ia. 'egla. del juego "n Ia. q ... e Se desenvuel\ren la ad ivid..d """'nOmica y Io~ negocio,

3 LO\Irar que los mercados .. n I~ que participan nu estros prodl>Ctos y 5erviClos sean m,b amplios, Y

4 E$lfmular 1>q""llos sectore. que, per .or inl .. nsivos en mano d .. obo-a y po< Sui ""rnc\e,islocas reglOOales. p<Jeden lene, mayor ,mpacto sabre e l empleo y el aballmienl0 de la POOrl!ZiI

En paral!lo. aCluaremo, con mayor ~ei~oOn en 1011 m~,~adM ~)(j~mM Prim!!r~, eomb31iend" las p<;,Clicas prOI&ccionista. q"" sl>fjan como ",.p"".13 emlnea 1,. ",1 .. a l aClual epi.odlo ,,,,,uivo de la econom;a mundial; segundo, disminuy .. nda laiHIs y clasifi"",dones aral'lCelaoias l>uscando eI ideal de COI11ar con arancele. "bal"" 1 pa,e",s"; le:C!!ro, Irabajando en 18 a,monizac:i6n d" norma. com8,c:ialu con """,slros 5Odo • ..., A.me-nca del Norte 1, <u .. rla, onlensif!C-llnd o '" p<uenc", y p'-'nelr~c:i~ de productos muk.no. en los me<l:aoos ni;llico$, con 10$ que se tiene "" d~fi(:~ sIQnlfk:all'o y q ... ~ ilabran de ser los de mayo' creomiento en e l mun(!o duranle k>s prO.imos at'\o~, ~si como en I~ mercaoo3 del , ur d e nue~tro oonlioente.

ESia agenda de raformar; coos1l!uye un prDgr.ma muy .mbieioso. congrutnt .. con 10 que t~ estt momenta demanda el .... i. Es un program .. con .entodo de u'gencia y visic.n de la<{lO plazo que fKlS permilir~ aumenta, la lasa de crecimiento a median<> pi3Z0, ""emas de continua' generarodo los " mpleas q"" requie,en la. n"""as ~n .... acione • .

E I Apoyo del 8anco Mundi"1

EI Banco Mundi1ll ha sido un MCIO confiabl!i: dan(jO apoyo no .010 a 10. e$fllCfZ05 de c:o~o plaza, Sino, taml>iM ~ . "" mb importante. " IllS 'elo:m n po lilicas e in~I,'""ion .. les de largo pl;!zo nt'ce~ari~s para nac:<!r viable\: "I~$ ~cdor1M de polilic •. En particu lilr. en las ~reas fF!ical y de ge.I,6n del ga .to publico . e h~ cont"do con " Iapoyo del Banco Mundia l medlanle el anallsOs y el dia logo 6f, r>oIitiea de m~s largo piazo sobre lamas como la efoeleneia del ga$lo pUblico, la~

- 47 -

SECRET ARIA DE HA CIEN DA Y CREDITO PU 6LICO

Subr.ec ,et a , ;a de Hacoenda y C,ed,lo Pubko

OIiCIO NO 102·6-173

M,b,co D F 20 <Ie OC1ub, .. de 2 009

,,,Iormn pru"P""states Y cootable~ asi corn!) COO pr~ SI"n1<>. de as."tenc,a teen,,,,, para .. I s..;terna de adrnmrstracioirl tnbulalia los trabiljo$ e n el sector r;..,,,,,dero contaroo con rnilione. conJOOIa:r gel eanco M~nd,~1 ~ el Fond() Mooela no Intcmil,'QI'Ial nl ,omo por ttC~"d~c;orl(!$ $ub$KII<!nlM d .. 3mba. instilllCoone. L. s<=o.reta na de Trabajo y P,evi.o<i" Soc",1 rnllnt,ene un di.iil()r}o CI![UHlO .00" , I mercildo laboral y sabre el dlsel'lo ~ evall.lilciOn de programas en este sector Firl almenle, el trabajo de l Sar.co Mundi"1 como un de l611&Or del li bore comerClO es fund amental para @eonomiullImergenles como Me~1OO que estill mlenl~m:lo ;nlegrarse cien1fo de las cadena$ de producdOn y distribuc06n global Ademii&. 10$ <!sru<!",o~ ,"", ... nt ... ~n ""oa"oIIo '01.1itucron81 del !1I.lema de adrnm,.traeoen Muana.l son eta"/) Mra redlJdr I ~~ tllSI~~ de transacci6n 3sociadol con 0.1 flujo "" mercanci .. ,

Esperamo, ""\lUir contando con Ia colalXlraciOn (ttl S~r.co Mundial e n I. innol/aeoon in.tituc,onat y de poIillcas q"" lorm.n pa~e de nuestro P"'9roma d .. de.arT"'" " "",diane> plazo Tan10 10, oefVick>& 1..,.""I",os como los serv.ao.. de conxim",nt" pro.'stos por 0.1 San<;.o Mundial s<>n ciertamente apreciados por nuestra Admmislrac:i6n

Atenlarnente, EI Subsecrelario,

0.<:'0 [If AIJuotl" Gullo""" Car ....... C."'e,,.. · Sea.""" <Ie H_""3 , GredolD PLr!Iico · So "0""':""""'0 · p,....,.. lie ~a_ OcIIoo . r ... ,. coo , • ..., ~. " do A • ......,. ,1'1".,_ .... do Hooond •• Su """"_ onIO .. _ '"

- 48 -

TRANSLATION OF THE LETTER OF DEVELOPMENT POLICY

Mr. Robert B. Zoelick, President, World Bank Mr. Zoellick: The world outlook has changed radically. The global recession that began in mid-2008 and deepened by the end of that year, occurred on an unprecedented scale, not seen in the past seven decades of world history. The Mexican economy has been particularly seriously affected by a combination of various adverse factors. This Letter of Development Policy describes Mexico's economic conditions, the main economic policy measures implemented by President Felipe Calderón and the 2010 Economic Program he submitted to Congress. Regarding Mexico’s relations with the World Bank in the current global economic context, the Mexican government has maintained an active agenda of dialogue and exchange of experiences and technical assistance with the World Bank in several of the essential areas of the institutional framework. This has permitted the implementation of counter-cyclical policies as well as macroeconomic policies that will contribute to the recovery and sustainable growth of the Mexican economy. In particular, the policy areas selected are linked to fiscal policy and public expenditure management, the financial system, labor policy and foreign trade. In view of the current circumstances, we are now asking for the actions being carried out in these areas to be backed by financial support from the World Bank. Macro-economic Environment The collapse of international trade and the sharp drop in U.S. industrial production translated into an abrupt fall in Mexican industry’s productive activity, which is closely linked to the U.S. manufacturing sector. Given the importance of foreign trade and industrial production in the Mexican economy, the global contraction was reflected in a steep decline in Mexico’s GDP during the first two quarters of this year. The international crisis has also led to a reduction in the availability of financing worldwide. The demand for financing in industrialized countries, capital losses in financing institutions and the review of financial regulation that is occurring worldwide will lead to less favorable financing conditions over the next few years. Mexico is also having to cope with the decline in oil production over the past four years, which is particularly unfortunate, given the high share of hydrocarbon revenue in Mexico’s public finances. Due to these adverse factors, Mexico's GDP is expected to drop by 6.8 percent in 2009. Positive sequential growth, however, is anticipated during the second half of 2009. In

- 49 -

addition to the stabilization and recovery that has begun to be observed in the world economy, Mexico has several elements that will contribute to its recovery after the crisis. The effects of implementing counter-cyclical policies on the fiscal and monetary fronts, as well as through development banka and by promoting infrastructure and housing are crucial elements. Other strengths include price stability, a highly capitalized, solvent financial system and a more competitive exchange rate. Challenges of Fiscal Policy One of the negative consequences of the international crisis has been that in the case of Mexico, it has led to a sharp decline in public revenue. The country’s public finances have been deeply affected by the combination of the drop in economic activity, derived from the international crisis and its lower oil production platform and oil prices. These factors have led to the greatest drop in oil and non-oil tax revenue in at least thirty years. Despite this, the use of non-recurring revenue such as the oil price hedge and stabilization fund savings have made it possible to protect spending in 2009. This has maintained the counter-cyclical impulse provided by public finances during the current spell of economic weakness. The country's public finances, however, are experiencing a structural problem associated with lower oil production, which requires immediate, equally structural solutions. In particular, the fiscal proposal President Calderón has submitted to Congress for consideration will lead to the orderly adjustment of public finances with the aim of strengthening them in the short and medium term. Thus, the economic program for 2010 will establish firmer revenue bases that will offset the reduction in oil revenue while encouraging growth and job creation and, of course, alleviating poverty. It is essential to undertake a fiscal reform that will enable us to deal with the current adverse situation, while allowing us to make up for the reduction in oil revenue due to lower hydrocarbon production. The aim is to achieve an optimal combination of measures that will continue to boost the economy and employment as much as possible without jeopardizing the viability of public finances in the medium term. This will be achieved by establishing a solid, efficient tax scheme that will be less vulnerable to the volatility of oil revenue, in which expenditure will be carried out transparently and efficiently and assigned to the main national priorities. The economic package proposed for 2010 will therefore have the following components:

I. A higher level of public debt by resorting to a temporary, moderate fiscal deficit linked to the cycle of the economy. This will be complemented by non-recurrent revenue and the use of savings.

II. An increase in the permanent collection of non-oil revenue through modifications to the tax regime and more efficient tax enforcement.

A temporary fiscal deficit and non-recurrent revenue will be used to offset the transitory drop in public income. The decline in oil production will be offset by the adjustment and

- 50 -

containment of public expenditure, accompanied by greater efficiency, transparency and accountability, together with an increase in the collection of non-oil tax revenue. Structural Agenda In addition to the structural vulnerability of public finances, due to their dependence on volatile oil prices and the decline in crude oil production are required actions that will enable us to speed up the growth of the Mexican economy. We must therefore set up a large, integral agenda and chart a clear course by means of a strategic policy that will enable us to boost the competitiveness of the Mexican economy, curb the growth of poverty and provide all Mexicans with opportunities to live better: the point is to propose a course of action that will go beyond the present and in addition to fostering the reactivation of the economy, establishes ambitious medium and long-term objectives. The reforms proposed in the sphere of competitiveness also complement fiscal reform: even with reforms to boost competitiveness, growth and investment are unlikely to increase in the absence of healthy public finances while the sustainability of public finances is a necessary but not a sufficient condition for rapid growth. Our economic growth and job creation rates are insufficient due to a low competitiveness. Priority must therefore be given to an agenda of actions in the economic sphere that will lead to higher growth. These actions must reflect the criterion that government can contribute more by facilitating the activity of the rest of the country's economic agents through an adequate legal, administrative and regulatory framework than through direct expenditure. To this end, it will be necessary to advance on four key fronts, namely:

1. To make input markets function better and therefore achieve greater competitiveness, particularly as regards labor relations, the telecommunications market, the energy sector, the financial system as a whole and investment in public infrastructure.

2. Improve the institutional framework that will determine the rules within which

economic activity and business take place. 3. Expand the markets in which our products and services participate and

4. Encourage those sectors which, by virtue of being labor intensive and because of

their regional characteristics, may have a greater impact on creating employment and alleviating poverty.

At the same time, we will act more assertively in external markets. First, by combating the protectionist measures that emerge as a misguided response to the world economy's current recession. Second, by lowering rates and tariff classifications to achieve the ideal of "low and flat” tariffs. Third, by working to harmonize trade regulations with our North

- 51 -

American partners. Fourth, by intensifying the presence and penetration of Mexican products in Asian markets in areas where there is a significant deficit and which should see the highest growth worldwide over the next few years as well as in markets in the south of this continent. This reform agenda undoubtedly constitutes a highly ambitious program, in keeping with what the country requires at this moment. It is a program combining a sense of urgency with long-term vision that will enable us to increase the medium-term growth rate in addition to continuing to create the jobs required by the upcoming generations. World Bank's Support The World Bank has been a reliable partner, supporting not only short-term efforts but also and even more importantly, the long-term political and institutional reforms required to make these policy actions viable. In particular, policies in the areas of taxation and public expenditure management were supported by an analysis and longer term policy dialogue on the efficiency of public spending, budgetary and accountancy reforms as well as technical assistance loans to the tax administration system. Actions in the financial sector were supported by joint missions by the World Bank and the International Monetary Fund as well as subsequent recommendations from both institutions. The Secretariat of Labor and Social Welfare maintains a close policy dialogue on the labor market and the design and evaluation of programs in the labor sector. Lastly, the World Bank’s work as a champion of free trade is crucial for emerging economies such as Mexico that are attempting to insert themselves into worldwide production and distribution chains. Likewise, recent efforts to promote the institutional development of the customs administration are crucial to reducing the transaction costs associated with the flow of merchandise. We hope to continue to enjoy the World Bank’s support in the institutional and policy innovation that forms part of our medium-term development program. Both the financial and knowledge services provided by the World Bank are deeply appreciated by our administration. Yours sincerely,

Alejandro M. Werner Undersecretary of Finance and Public Credit

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ure

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ram

de

sign

, bud

get

plan

ning

, dec

isio

n m

akin

g an

d ex

ecut

ion

Ado

pt a

sys

tem

for

the

man

agem

ent

of

publ

ic e

xpen

ditu

re p

erfo

rman

ce

info

rmat

ion

at t

he d

iffe

rent

lev

els

of

gove

rnm

ent

Pub

lic

Sec

tor

Bor

row

ing

Req

uire

men

ts (

% o

f G

DP

) B

ase

2008

: 2.

1 P

rogr

am 2

009:

2.7

P

rogr

am 2

010:

3.1

P

rogr

amm

able

E

xpen

ditu

re (

% o

f G

DP

) B

ase

2008

: 18

.4

Pro

gram

200

9: 1

9.1

Pro

gram

201

0: 1

8.7

Non

-oil

tax

rev

enue

(%

of

GD

P)

Bas

e 20

08:

10.0

P

rogr

am 2

009:

9.3

, P

rogr

am 2

010:

10.

3 A

dopt

ion

in t

he F

eder

al

Pub

lic

Adm

inis

trat

ion,

31

Sta

tes

and

the

Fed

eral

D

istr

ict

of a

har

mon

ized

bu

dget

cla

ssif

icat

ion

syst

em a

s ce

rtif

ied

by t

he

Nat

iona

l C

ounc

il o

f A

ccou

ntin

g H

arm

oniz

atio

n P

olic

ies

and

inst

itut

iona

l re

form

s in

ita

lics

and

in

the

mid

dle

colu

mn

are

the

prio

r ac

tion

s of

the

pro

pose

d D

PL

- 53

-

Pol

icy

area

ob

ject

ive

Pro

gres

s in

pol

icie

s an

d in

stit

uti

onal

ref

orm

to

ach

ieve

pol

icy

area

ob

ject

ive

Ou

tcom

e In

dic

ator

s

Pre

-Glo

bal

Cri

sis

Du

rin

g th

e G

lob

al C

risi

s P

rior

Act

ion

s P

ost

Cri

sis/

Med

ium

Ter

m

Dev

elop

men

t P

olic

y A

rea

2 F

inan

cial

sec

tor

pol

icie

s F

oste

r (i

) st

abil

ity

of

the

fina

ncia

l sy

stem

and

(i

i) a

cces

s to

fi

nanc

e to

pr

omot

e gr

owth

and

im

prov

emen

ts in

ho

useh

olds

’ li

ving

st

anda

rds

Str

engt

heni

ng o

f pr

uden

tial

reg

ulat

ions

and

ri

sk m

anag

emen

t in

the

bank

ing

sect

or

Ena

ctm

ent o

f ne

w le

gal f

ram

ewor

k th

at

prov

ides

mor

e fl

exib

le o

ptio

ns f

or b

ank

reso

luti

on, r

egul

ates

info

rmat

ion

exch

ange

be

twee

n re

leva

nt a

genc

ies,

and

impr

oves

le

gal p

rote

ctio

n fo

r pr

osec

utor

s (2

006)

.

Est

abli

shm

ent o

f ne

w le

gal f

ram

ewor

k fo

r th

e op

erat

ion

of c

redi

t inf

orm

atio

n bu

reau

s (2

001)

, and

issu

ance

of

rela

ted

regu

lati

ons

by C

NB

V.

Ena

ctm

ent o

f ne

w S

ecur

itie

s M

arke

ts L

aw

to e

nhan

ce tr

ansp

aren

cy, s

tren

gthe

n co

rpor

ate

gove

rnan

ce a

nd p

rote

ct m

inor

ity

shar

ehol

ders

’ ri

ghts

, and

fac

ilit

ate

acce

ss to

st

ock

mar

ket l

isti

ng (

2005

and

200

9), a

nd

issu

ance

of

rela

ted

regu

lati

ons

by C

NB

V

Ena

ctm

ent o

f th

e L

aw o

n T

rans

pare

ncy

of

Fin

anci

al S

ervi

ces

Rat

iona

liza

tion

of

Dev

elop

men

t Fin

anci

al

Inte

rmed

iari

es (

DF

I), c

onsi

dera

ble

impr

ovem

ents

in th

eir

gove

rnan

ce a

nd

over

all f

inan

cial

per

form

ance

, and

de

velo

pmen

t of

inno

vati

ve in

stru

men

ts to

pr

omot

e m

arke

t dev

elop

men

t.

Enh

ance

men

t of

cons

umer

pro

tect

ion,

acc

ess

to

fina

nce

and

mar

ket t

rans

pare

ncy

by (

a)

amen

ding

the

Law

Pro

tect

ing

Use

rs o

f Fin

anci

al

Serv

ices

to e

xpan

d th

e re

gula

tory

and

su

perv

isor

y ca

paci

ties

of C

ON

DU

SEF

as

publ

ishe

d in

the

Off

icia

l Gaz

ette

on

June

25,

20

09;

(b)

amen

ding

Art

icle

46

Bis

1 o

f the

Law

of

Cre

dit I

nsti

tuti

ons

to fa

cili

tate

ban

king

th

roug

h ag

ents

as

publ

ishe

d in

the

Off

icia

l G

azet

te o

n Ju

ne 2

5, 2

009;

and

(c)

am

endi

ng

frac

tion

VI

Bis

of a

rtic

le 1

04 o

f the

Cap

ital

M

arke

ts L

aw r

equi

ring

issu

ers

to p

rovi

de

info

rmat

ion

to th

e C

NB

V a

nd to

rel

evan

t sto

ck

exch

ange

s ab

out t

he is

suer

der

ivat

ive

posi

tion

s an

d po

ssib

le c

onti

ngen

cies

that

sai

d de

riva

tive

po

siti

ons

impl

y fo

r th

e re

leva

nt is

suer

’s

fina

ncia

l sit

uati

on a

s pu

blis

hed

in th

e O

ffic

ial

Gaz

ette

on

May

6,2

009.

E

nhan

cem

ent o

f the

tran

spar

ency

and

impa

ct o

f st

ate

owne

d de

velo

pmen

t fin

anci

al in

stit

utio

ns

(DF

Is)

by a

men

ding

the

Cre

dit I

nsti

tuti

ons

Law

as

pub

lish

ed in

the

Off

icia

l Gaz

ette

on

May

6,

2009

and

est

abli

shin

g th

at:

a) D

FIs

sha

ll

publ

ish

mon

itor

ing

indi

cato

rs th

at e

valu

ate

the

serv

ices

pro

vide

d by

the

rele

vant

inst

itut

ion

(art

31

), a

nd b

) SH

CP

sha

ll a

nnua

lly

carr

y ou

t and

pu

blis

h tw

o ev

alua

tion

s (i

n w

hich

at l

east

two

acad

emic

inst

itut

ions

nee

d to

par

tici

pate

) of

D

FIs

(ar

t 55

Bis

2).

Am

endm

ents

to

the

Law

of

Cre

dit I

nsti

tuti

ons

to e

nhan

ce

the

bank

res

olut

ion

fram

ewor

k.

Ena

ctm

ent o

f le

gal a

men

dmen

ts

to e

nhan

ce th

e re

gula

tion

and

su

perv

isio

n of

SO

FO

LE

S

Str

engt

heni

ng o

f pr

uden

tial

re

gula

tion

s w

ithi

n th

e fr

amew

ork

prop

osed

by

the

G-

20

Con

tinu

ed in

stit

utio

nal

stre

ngth

enin

g of

DF

Is.

Ave

rage

qua

lity

of

info

rmat

ion

prov

ided

by

fina

ncia

l in

term

edia

ries

to u

sers

of:

(i

) cr

edit

car

ds

base

Jun

e 20

09 8

.0 p

rogr

am

2010

9.0

(i

i) c

heck

ing

acco

unts

ba

se J

une

2009

7.8

p

rogr

am 2

010

8.5

(iii

) m

ortg

age

loan

s

base

Jun

e 20

09 7

.7 p

rogr

am

2010

8.5

(a

s m

easu

red

by C

ON

DU

SE

F’s

“C

alif

icad

or”)

N

umbe

r of

tota

l out

lets

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nclu

ding

ban

k br

anch

es)

that

pr

ovid

e ba

nkin

g se

rvic

es

Bas

e 20

08: 1

0,35

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rogr

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Inc

reas

e by

35

perc

ent.

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o in

depe

nden

t eva

luat

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on

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tegi

c pr

ogra

ms

of

deve

lopm

ent b

anks

con

duct

ed

Pub

lica

tion

of

impa

ct in

dica

tors

of

dev

elop

men

t ban

ks in

re

achi

ng th

e ta

rget

ed p

opul

atio

n

P

olic

ies

and

inst

itut

iona

l ref

orm

s in

ital

ics

and

in th

e m

iddl

e co

lum

n ar

e th

e pr

ior

acti

ons

of th

e pr

opos

ed D

PL

- 54

-

P

olic

y ar

ea

obje

ctiv

e P

rogr

ess

in p

olic

ies

and

in

stit

uti

onal

ref

orm

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ach

ieve

pol

icy

area

ob

ject

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Ou

tcom

e In

dic

ator

s

Pre

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bal

Cri

sis

Du

rin

g th

e G

lob

al C

risi

s P

rior

Act

ion

s P

ost

Cri

sis/

Med

ium

Ter

m

Dev

elop

men

t P

olic

y A

rea

3: L

abor

pol

icie

s Im

prov

e em

ploy

abil

ity

of t

he l

abor

fo

rce

Incr

ease

lab

or

prod

ucti

vity

an

d w

ages

P

rote

ct l

abor

in

com

es

duri

ng

rece

ssio

ns

Act

ive

Lab

or M

arke

t P

olic

ies

to d

eal

wit

h cy

clic

al a

nd s

truc

tura

l pr

oble

ms.

The

fo

llow

ing

exis

ting

pro

gram

s ha

ve b

een

mod

ifie

d an

d re

stru

ctur

ed t

hrou

ghou

t th

e 90

s an

d ea

rly

2000

s:

• T

empo

rary

Em

ploy

men

t P

rogr

am

(PE

T)

in r

ural

are

as (

an i

ncom

e an

d la

bor

supp

ort

prog

ram

for

pop

ulat

ions

af

fect

ed b

y em

erge

ncie

s)

• N

atio

nal

Em

ploy

men

t S

ervi

ce (

SN

E):

an

ove

rarc

hing

um

brel

la o

f la

bor

serv

ices

inc

ludi

ng l

abor

int

erm

edia

tion

, in

form

atio

n m

echa

nism

s an

d tr

aini

ng

(i.e

. BE

CA

TE

)

Stre

ngth

enin

g an

d en

hanc

emen

t of

ac

tive

lab

or m

arke

t po

lici

es b

y (a

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prov

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inst

itut

iona

l se

tup

of t

he

Tem

pora

ry E

mpl

oym

ent

Pro

gram

(P

ET

) by

inc

ludi

ng t

he S

ub-s

ecre

tari

at o

f E

mpl

oym

ent

and

Lab

or P

rodu

ctiv

ity

in

the

tech

nica

l co

mm

itte

e th

at c

oord

inat

es

the

PE

T a

nd (

b) a

llow

ing

the

PE

T t

o be

im

plem

ente

d in

urb

an a

reas

in

addi

tion

to

rur

al a

reas

.

Fur

ther

exp

ansi

on (

mor

e re

sour

ces

and

cove

rage

) an

d co

nsol

idat

ion

(bet

ter

qual

ity

and

prog

ram

ef

fici

ency

) of

Act

ive

Lab

or M

arke

t po

lici

es

Sub

mis

sion

and

app

rova

l of

a r

efor

m

to t

he F

eder

al L

abor

Law

Num

ber

of b

enef

icia

ries

hir

ed

thro

ugh

PE

T

Bas

e 20

08:

365

thou

sand

P

rogr

am 2

009:

600

tho

usan

d P

rogr

am 2

010:

650

tho

usan

d

Num

ber

of w

ork-

shif

ts c

ontr

acte

d th

roug

h P

ET

B

ase

2008

: 11

.9 m

illi

on

Pro

gram

200

9: 2

9.3

mil

lion

P

rogr

am 2

010:

35.

1 m

illi

on

Pol

icie

s an

d in

stit

utio

nal

refo

rms

in i

tali

cs a

nd i

n th

e m

iddl

e co

lum

n ar

e th

e pr

ior

acti

ons

of t

he p

ropo

sed

DP

L

- 55

-

Pol

icy

area

ob

ject

ive

Pro

gres

s in

pol

icie

s an

d i

nst

itu

tion

al r

efor

m t

o ac

hie

ve p

olic

y ar

ea o

bje

ctiv

eO

utc

ome

Ind

icat

ors

P

re-G

lob

al C

risi

s D

uri

ng

the

Glo

bal

Cri

sis

Pri

or A

ctio

ns

Pos

t C

risi

s/ M

ediu

m T

erm

D

evel

opm

ent

Pol

icy

Are

a 4:

Tra

de

pol

icie

s D

eepe

n in

tegr

atio

n in

to t

he w

orld

ec

onom

y

Red

uce

trad

e co

sts

Incr

ease

tr

ansp

aren

cy

and

lega

l ce

rtai

nty

in

trad

e re

gula

tion

s

Bet

wee

n 20

02 a

nd 2

006

MF

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arif

fs w

ere

unil

ater

ally

red

uced

for

app

roxi

mat

ely

6,00

0 ta

riff

hea

ding

s im

plyi

ng a

red

ucti

on

in t

he a

vera

ge M

FN

tar

iff

from

16.

5 pe

r ce

nt t

o 11

.2 p

er c

ent

In o

rder

to s

trea

mli

ne r

egul

ator

y an

d op

erat

iona

l pr

oced

ures

the

PIT

EX

and

M

aqui

la p

rogr

ams

wer

e am

alga

mat

ed u

nder

th

e D

ecre

e on

the

Pro

mot

ion

of

Man

ufac

turi

ng I

ndus

try

and

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ort

Ser

vice

s (I

MM

EX

, 200

6) a

nd s

peci

al

ince

ntiv

es t

o at

trac

t re

man

ufac

turi

ng

com

pani

es w

ere

crea

ted

wit

hin

the

IMM

EX

pr

ogra

m (

2008

)

Cre

atio

n of

a p

rogr

am t

o ac

cele

rate

the

cu

stom

s fo

rmal

itie

s of

hig

h-vo

lum

e ex

port

ing

com

pani

es a

nd o

f an

Int

egra

ted

Com

pute

rize

d C

usto

ms

syst

em (

SA

AI)

to

faci

lita

te c

usto

ms

clea

ranc

e in

clud

ing

the

intr

oduc

tion

ele

ctro

nic

clea

ranc

e re

ques

ts

Red

ucin

g th

e M

ost

Fav

ored

Nat

ion

tari

ffs

on m

anuf

actu

red

impo

rts

and

incr

easi

ng t

he n

umbe

r of

dut

y-fr

ee t

arif

f li

nes

in a

sta

ged

man

ner

over

a f

ive

year

pe

riod

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rtin

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nuar

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200

9 in

or

der

to e

nhan

ce t

rade

, com

peti

tive

ness

an

d si

mpl

ific

atio

n of

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ext

erna

l tr

ade

tari

ff s

truc

ture

by

amen

ding

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Tar

iff

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for

Gen

eral

tax

es o

n Im

port

s an

d E

xpor

ts a

s pe

r D

ecre

e pu

blis

hed

in t

he

Off

icia

l G

azet

te o

n D

ecem

ber

24, 2

008.

Impl

emen

tati

on o

f ta

riff

red

ucti

on

acco

rdin

g to

sch

edul

e C

reat

e an

alt

erna

tive

to

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EX

that

ad

dres

ses

fisc

al r

isk

in e

xist

ing

syst

em a

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acil

itat

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cces

s to

re

liab

le c

ompa

nies

Im

plem

enta

tion

of

mea

sure

s to

re

duce

cos

ts o

f tr

ade

regu

lati

ons

by

incr

easi

ng n

umbe

rs o

f br

oker

s,

elim

inat

ion

of d

upli

cate

pro

cess

es b

y cu

stom

s ag

ents

, alo

ng w

ith

effo

rts

to

impr

ove

info

rmat

ion

tech

nolo

gy, t

o ex

pand

the

pre

-val

idat

ion

proc

esse

s,

stre

amli

ne r

evie

w a

nd c

lear

ance

pr

oces

ses,

S

tren

gthe

n cu

stom

s m

oder

niza

tion

, fu

rthe

r si

mpl

ific

atio

n of

pro

cedu

res

such

as

impl

emen

tati

on o

f si

ngle

w

indo

w, a

nd im

prov

e tr

ansp

aren

cy.

Ave

rage

gen

eral

tar

iff

rate

s fo

r m

anuf

actu

ring

im

port

s B

ase

2008

: 10.

4 pe

rcen

t P

rogr

am 2

009:

8.3

per

cent

P

rogr

am 2

010:

5.2

per

cent

S

hare

of

gene

ral

tari

ff r

ate

for

man

ufac

ture

d im

port

s th

at c

an b

e im

port

ed d

uty

free

B

ase

2008

: 20

perc

ent

Pro

gram

200

9: 2

4 pe

rcen

t P

rogr

am 2

010:

61

perc

ent

Pol

icie

s an

d in

stit

utio

nal

refo

rms

in i

tali

cs a

nd i

n th

e m

iddl

e co

lum

n ar

e th

e pr

ior

acti

ons

of th

e pr

opos

ed D

PL

- 56 -

ANNEX 3. FUND RELATIONS NOTE

IMF Executive Board Completes Review of Mexico’s PerformanceUnder the Flexible Credit Line Press Release No. 09/362October 16, 2009 The Executive Board of the International Monetary Fund (IMF) today completed its six-month review of Mexico’s qualification for thearrangement under the Flexible Credit Line (FCL) and reaffirmedMexico’s continued qualification to access FCL resources. TheMexican authorities have indicated that they intend to continue treating the arrangement as precautionary and do not intend to draw onthe line. The one year arrangement for Mexico for SDR 31.5 billion (aboutUS$47 billion), approved in April 17, 2009 (see Press Release No. 09/130) was the first commitment under the IMF’s FCL, which wascreated in the context of a major overhaul of the Fund’s lendingframework on March 24, 2009 (see Press Release No. 09/85 and Public Information Notice 09/40). Following the Executive Board discussion of Mexico, Mr. JohnLipsky, First Deputy Managing Director and Acting Chairman of the Board, made the following statement: “Six months ago, with the global financial crisis near its peak, the IMFExecutive Board approved for Mexico the first Flexible Credit Line(FCL) arrangement in the history of the Fund. The goal of the FCL is to provide insurance against tail risks beyond the control of countryauthorities. In Mexico, the authorities’ responsive policy actions,additional financing from the international community, coupled withthe FCL have in the last months supported a reduction in perceptions of tail risks and contributed to stabilization in financial marketconditions. Today, the IMF Executive Board has completed a reviewthat reaffirmed that Mexico continues to meet the qualification criteriafor access to FCL resources. “Despite its strong policy frameworks, the current global economicand financial environment has hit Mexico harder than expected. Theeconomy is in the deepest recession since the 1994-95 crisis, reflecting especially close links to the U.S. economy. However, recent indicators show some signs of recovery and overall growth is expected to pick upin the second semester of this year. Meanwhile, corporate externalfinancing conditions have eased and the balance of payments situationremains manageable.

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“However, Mexico’s very strong policy framework, which underpinsits qualification for the FCL, has helped cushion the impact of theglobal crisis. The flexible exchange rate has adjusted, the inflationtargeting framework has provided an anchor for expectations, and the fiscal rule and strengthened public sector balance sheets have averteddisruptive moves in risk premia. The well capitalized banking systemand strong supervisory framework provide assurances that challengesto the financial sector from the sharp growth slowdown will be met. “In a signal of their commitment to pursuing very strong policies, theauthorities have proposed an ambitious fiscal reform to the Congressthat seeks to strike a balance between the need to begin the process offiscal consolidation, while smoothing as much as possible thewithdrawal of fiscal support to the economy. The proposed measures,in conjunction with the existing fiscal framework, continue to ensuremedium term fiscal sustainability. Monetary policy continues to be guided by the inflation targeting framework and expectations remainwell anchored. “Against this backdrop of very strong policy frameworks and actions,the Executive Board today reaffirmed that Mexico continues to meetthe qualification criteria for the FCL. Accordingly, resources under the FCL—which the authorities have indicated that they intend to continueto treat as precautionary—will remain available through April next year,” Mr. Lipsky said. IMF EXTERNAL RELATIONS DEPARTMENT

Public Affairs Media Relations

Phone:202-623-7300Phone: 202-623-7100

Fax: 202-623-6278Fax: 202-623-6772

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ANNEX 4. MACROECONOMIC & DEBT SUSTAINABILITY ASSESSMENT

1. Mexico is in the midst of a deep recession as it faces the impacts of strained global financial conditions, a sharp contraction in international trade and the outbreak of the A/H1N1 flu. Based on seasonally adjusted quarterly GDP statistics the economic recession in Mexico started as early as the third quarter of 2008 and the downturn has been particularly sharp during the fourth quarter last year and the first quarter of 2009 (see figure 1a). The outbreak of the flu epidemic in the last week of April aggravated the economic downturn during the second quarter of the year.54 Economic activity during the first half of this year has been down by 9.2 percent compared to the same period of the previous year.

2. The global financial crisis led to a sharp tightening of financing conditions in a large number of emerging market economies. Mexico has been no exception. In response to the global financial crisis and emerging market sell-off, the Mexican authorities implemented several policy actions to maintain and restore liquidity on domestic financial markets including foreign exchange interventions, the provision of loans and loan guarantees to domestic firms by government owned development banks and the repurchase and reduced issue of longer-term government bonds. Nevertheless, there was a substantial depreciation of the currency, and the flexible exchange rate continues to operate as a key instrument and signaling device for the rapid adjustment of the economy to external shocks.

3. Prior to the onset of the global economic downturn, Mexico experienced moderate growth within a framework of enhanced macroeconomic stability. GDP growth averaged 3.8 percent annually between 2004 and 2007; fiscal policy successfully focused on a reduction of the public sector deficit and a decline in the public sector debt-to-GDP ratio, and enhanced price stability contributed to a healthy domestic credit expansion and growth of domestic demand.

4. Economic activity suffered a severe contraction throughout the world. Mexico’s annual economic growth decelerated substantially as the economy entered into a recession towards the second half of 2008, leading to a more limited GDP growth of 1.3 percent for the year. The current base case scenario for Mexico includes a contraction of economic activity by 6.8 percent in 2009 which, in view of the dismal performance of the economy during the first semester requires a substantial recovery of activity in the second half of the year.

54 The Government estimates that the contraction of economic activity that can be attributed to the flu outbreak is about 0.3 to 0.5 percent of GDP this year and is concentrated in the 2nd quarter of the year (Presentation Dr. Carstens to the Senate August 11, 2009)

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Figure 1 a-f: Real Economy Indicators a) The Mexican economy faces the worst recession since the Tequila crisis…

b)... the result of a sharp aggregate demand contraction

c) Fall in exports, due to a weaker external demand, has been accompanied by a strong reduction in imports

d) Manufacturing industry is closely correlated to a significantly weaker US industry….

e) …leading to job losses and higher levels of unemployment. f) Under this scenario, economic perspectives were sharply adjusted downward, though stabilizing more recently.

GDP Growth

-30%

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-14%

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2%

10%

07:I 07:II 07:III 07:IV 08:I 08:II 08:III 08:IV 09:I 09:II

y oy % qoq% annualized -30%

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-6%

2%

10%

06:IV 07:I 07:II 07:III 07:IV 08:I 08:II 08:III 08:IV 09:I 09:II

Demand and Supply Components (yoy%)

Consumption Investment Exports Imports

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22

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28

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$ b

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Exports

Total Manufacturing

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Industrial Production Index

US Industrial Prod. 2002=100

Mexico Manufact. Prod. 2003=100

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Unemployment Rate (%) seasonally adjusted

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Growth Forecast (%) : GDP 2009

Mex USA

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5. The Mexican Government implemented counter-cyclical fiscal stimulus policies to mitigate the impact of the external demand shock on the domestic economy. The fiscal stimulus policies adopted include additional public investment in infrastructure incorporated in the 2009 budget as well as employment programs, a reduction and freeze of public sector administrated prices in the energy sector and an expansion of development banks’ credit programs.

6. The contraction of economic activity is leading to a sharp decline in tax revenue making it difficult to sustain planned public expenditure levels. During the first eight months of this year non-oil tax revenue dropped by 13 percent in real terms while Value Added Tax revenue plummeted by 20 percent. The Government plans to compensate lower oil and non-oil budget revenue this year, currently estimated at MXN 477.5 billion (US$35 billion, 4 percent of GDP) with non-recurrent resources from a successful oil hedge, an extraordinary transfer of profits from the central bank and drawing resources from the Government’s revenue stabilization funds. In addition, lower federal Government revenue automatically translates in less revenue shared with states and municipalities. Finally, the Government announced public expenditure cuts to a total amount of MXN 85 billion (US$6.5 billion, 0.7 percent of GDP)55 in order to keep the 2009 budget balance targets on track.

7. Extraordinary revenue sources used to compensate the shortfall in fiscal revenue this year will not be available in 2010 prompting additional fiscal adjustment in next year’s budget. The Government’s budget projections for 2010 show a revenue shortfall of MXN 374 billion (US$29 billion, 3.0 percent of GDP) compared to the expected revenue in the 2009 budget. The Government proposes to close this gap by a combination of expenditure reductions, revenue enhancing measures and allow for a higher deficit.56 The Mexican fiscal responsibility law requires a balanced budget57 and allows for a deficit only under “exceptional circumstances” and conditioned by the adoption of a medium term fiscal framework to return to a balanced budget. The sharp decline in public sector revenue due to the current cyclical downturn is further aggravated by a rapidly falling volume of oil production leading to a more structural challenge to replace diminishing oil revenue by more permanent sources of revenue. The Government is proposing a mix of tax policy measures and adjustments in public sector administrated prices (mainly in the energy sector) and a discussion in Congress is underway to decide on the mix of revenue and expenditure measures. Therefore, the fiscal package seeks to

55 An initial amount was announced last May and the total in August of 2009. 56 The government submitted its budget proposal for 2010 to Congress on September 8, 2009 in which it proposes to cover the permanent component of the revenue shortfall, estimated at 1.7 percent of GDP, by expenditure cuts and revenue enhancing measures, leaving a transitory component of the shortfall to be financed by additional deficit spending, 0.5 percent of GDP, and non-recurrent extraordinary revenue, 0.8 percent of GDP. 57 A modification to the law adopted by Congress in 2009 includes all investments by the public sector oil company in the budget but excludes these investments from the budget balance requirement. Those investments are currently estimated to amount to 2.1 percent of GDP for 2009 and 2.0 percent in 2010. As a result the budget deficit for 2009 is estimated at 2.1 percent of GDP, while for 2010 the government proposes a budget deficit of 2.5 percent of GDP (i.e. 2.0 percent oil sector investment and an additional 0.5 percent temporary deficit spending).

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strike a balance between the need for fiscal consolidation to assure markets of fiscal sustainability while smoothing out the withdrawal of fiscal stimulus. In this regard, credit rating agencies have also warned that there is the need for a clear and credible medium-term fiscal strategy of revenue-enhancing measures or sustainable spending cuts to compensate for lower public sector revenue.

8. Monetary policy started to ease since January 2009 in order to support other efforts to reduce the downturn in economic activity. Even though consumer price inflation continues at a level, 4.9 percent last September, which is substantially above the authorities’ medium-term target of 3 percent. The severity of the economic downturn has led the authorities to reduce its target for the overnight interbank interest rate by an accumulated 375 basis points between January and July this year, from 8.25 to 4.50 percent. The central bank currently projects to reach its medium-term inflation target towards the end of 2010 and forecasts an inflation of 4.0-4.5 percent by the end of 2009. The revenue raising measures in the fiscal package may provide an additional challenge to the monetary authorities to assure that their impact on headline inflation remains a one-off event.

9. The authorities have taken several actions to maintain orderly conditions on foreign exchange and domestic financial markets in view of the unprecedented global financial shocks. The central bank intervened in foreign exchange markets providing foreign currency liquidity to the private sector. Sales of international reserves through different intervention mechanisms summed to US$30 billion between October 2008 and August 2009. Though Mexico maintains a level of international reserves relative to short term debt and imports that is below the level observed in several other emerging market economies and currency interventions reduced reserves to US$76 billion by August 2009 compared to US$85 billion in September 2008, indicators of foreign reserve adequacy continue well above conventional thresholds of 100 percent relative to short-term external debt or three to six months of imports. Furthermore, bilateral and multilateral support, through a US$30 billion currency swap arrangement with the US Federal Reserve (extended until February, 2010) and a US$47 billion Flexible Credit Line (FCL) with the IMF, provide for additional precautionary sources of external funds. Announcement of the one-year FCL last April greatly reduced volatility of the peso. Moreover, the revenues from the oil hedge which will be received in November should lead to a level of reserves similar to the one observed in September of last year.

10. The Mexican Government, through its development banks, also stepped in to facilitate refinancing of corporate debt and to support securitized private housing finance on the private domestic bond market. Issuance of private domestic securities (financial and non-financial) was severely disrupted. No medium-term bond issues were made during October and November last year and the issuance of short-term paper also

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Figure 2 a-f: Financial Indicators a) Increased risk pricing has been reflected in significantly higher sovereign risk spreads…

b)...and in a sharp depreciation and volatile exchange rate

c) The share of foreign holdings of Government bonds declined abruptly…

d)...the financial asset sell-off is reflected in a sharp increase in the yield on long-term Government bonds.

e) Domestic finance cost for the Mexican companies increased…

f)…as private domestic issuance of medium- term securities was disrupted.

150

300

450

600

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Oct

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Dec

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Feb

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Jun-

09

Aug

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Oct

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Sovereign Risk Spreads(EMBI Global basis points over US Treasury)

Mexico LAC9.5

10.5

11.5

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13.5

14.5

15.5

Aug

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Oct

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Exchange Rate(peso/dollar)

6%7%8%9%

10%11%12%13%14%15%16%

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Foreign holdings of government bonds as % of total government bonds outstanding

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Domestic Bond Yield(%)

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Bond 10Y Bond 20Y

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Spread in national currency (commercial paper to overnight rate in basis points)

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billio

n pe

sos

Corporate Securities Issuance

Medium Term Short Term

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declined significantly (see figure). A bankruptcy filing of a major AAA58 rated company following large losses on currency related derivatives impaired the non-financial corporate commercial paper market. To maintain the flow of credit and allow corporations to refinance, NAFIN and Bancomext designed an emergency program through which they guaranteed up to 50 percent of domestic corporate paper issuances. Sociedad Hipotecaria Federal, the Government’s private housing finance development bank, stepped in to avoid a collapse of the nascent Residential Mortgage Backed Security (RMBS) market and support the flow of credit to mortgage originating non-bank credit institutions (Sofoles and Sofomes). After a default by two mortgage Sofoles on the commercial paper, the SHF designed a program to guarantee up to 65 percent of bonds issued by mortgage Sofoles enabling them to refinance debt maturing in 2009 and 2010.

11. Credit to the non-financial private sector has started to contract. Despite a brief period of double digit growth over the past few years, the level of credit to the private sector in Mexico remains, at about 30 percent of GDP, low compared to other countries in the region or at comparable levels of economic development. Growth of credit slowed down last year and has started to contract over the past few months once one adjusts credit growth, in constant domestic currency terms, for the depreciation of the exchange rate. About a quarter of the amount of credit outstanding to the private sector is expressed in foreign currency and a depreciation of the peso increases the peso equivalence of the amount outstanding without any additional credit flow taking place. As can be observed from figure 3, the growth of credit in real, domestic currency terms dropped sharply over the past three quarters to a contraction by the second quarter of 2009 of 2.4 percent.

12. The most affected sector for this slowdown trend in credit is the household sector. After a six-year period of high, double digit growth of consumer credit, led by the credit card business, a significantly increasing non-performing consumer credit loan portfolio led financial intermediaries to cut back on the expansion of consumer credit already before the impact of the global financial crisis was felt in Mexico. Consumer credit started to present a negative growth rate since the last quarter of 2008 and data for June 2009 show a sharp contraction of 17 percent (Figure 3). The more remarkable development over the past few months in the slowdown of growth and eventual contraction of credit is observed in the performance of credit to non-financial private sector firms and in housing finance, accounting for some 59 and 27 percent of total credit to the non-financial private sector. Housing loans presented still a moderate expansion of 2 percent at the second quarter of 2009. As expected, the credit crunch is particularly noted in the externally originated and foreign currency denominated segment of credit to private sector firms that observed an annual contraction by 11 percent in the second quarter this year (after adjusting for the depreciation of the peso). The positive growth persisting in the domestic finance to companies does not any longer compensate the dramatic drop of external credit flows; total financing to Mexican firms decreased by 1 percent in the second quarter of 2009.

58 On a local scale

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13. The current economic recession is characterized by a simultaneous sharp contraction in private consumption, investment and exports. While the latter is due to a more generalized drop in external demand and international trade, the rapid tightening in domestic demand can be attributed to increased uncertainty regarding global and domestic economic prospects, increased unemployment, reduced availability of credit, and a significant currency depreciation. GDP data for the first semester show a particularly fast and sharp response by households and businesses to the rapidly deteriorated financial and economic situation as private consumption contracted by 9.2 percent and investment by 11.5 percent contributing significantly to the overall contraction of GDP.59 Weak private consumption and investment activity is also reflected in a rapid decline of imports, down by 31 percent in nominal dollar terms during the first eight months of the year. Exports over the same period were down by 30.2 percent. It should be noted that there is a close link between export and import declines, as more than 70 percent of imports are intermediate goods, many of which are used as inputs for export production.

Figure 3 Credit to the non-financial private sector, 2006-2009

Source: Bank staff estimates based on Banco de México

14. With additional data becoming available, there seems to be an emerging consensus that the global economic downturn is currently bottoming out, even though there remains considerable uncertainty with regards to the strength of the rebound. Assumptions regarding the external environment have a major impact on the projection of Mexico’s main macroeconomic variables over the next two years. A base case scenario (Table 1) follows the Bank’s Unified Survey Assumptions of September 2009 for global economic activity.60 The impact of such an external scenario on the Mexican economy is a significant recession in 2009 and a modest rebound by 2010 and 2011. The sharp reduction in the external demand in the base case scenario in 2009 is reflected in a

59 See also Annex 5a figure 1 60 World output is projected to fall by 2.5 percent in 2009 and experiencing a gradual recovery in 2010 when growth is picking up to 2.3 percent. Similarly output in the United States is projected to contract by 2.5 percent in 2009 before rebounding by 2.3 percent in 2010.

-6%

-3%

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3%

6%

9%

12%

15%

18%

06:I

06:II

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07:II

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Growth of total financing

Non adjusted

Adjusted

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Housing

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significant contraction in the dollar value of exports, with the value of oil exports mainly declining as a result of lower oil prices whereas non-oil exports largely decline due to lower volumes of production and trade. The latter in combination with tighter credit conditions (both external and domestic) is projected to lead to a simultaneous sharp contraction of private consumption and investment. Countercyclical Government expenditures cannot avoid a sharp contraction of aggregate demand and economic activity in 2009. A gradual recovery of external demand by 2010 should allow, on the contrary, for an increase of manufactured exports, private consumption and investment demand providing for a modest expansion of overall economic activity. Risks to this scenario are largely tilted towards the downside and a second, low case scenario provides for the impact on Mexican macroeconomic indicators in case of a sharper reaction in terms of the domestic demand contraction in the short run and a more protracted recession in its largest trading partner and the global economy, reflected in a less vigorous rebound in the volume of exports and a lower international oil price in 2010 and 2011.

Table 1. Macroeconomic scenarios

Source: Bank staff estimates

15. In either scenario concerns are focused on the rising fiscal pressures in view of the rapidly deteriorating outlook for public sector revenue and the increasing public debt-to-GDP ratios. Fiscal discipline and strong fiscal policy frameworks, including the establishment of stabilization funds and the acquisition of oil price hedges, enabled a countercyclical policy response for 2009. The public debt-to-GDP ratio posted an

Indicator 2008 2009 2010 2011 2009 2010 2011

Real GDP (%) 1.4% -6.8% 3.0% 4.0% -8.5% 1.0% 2.0%

Consumption (%). 1.4% -6.3% 3.2% 3.9% -9.0% 0.5% 2.2%

Investment (%) 5.3% -14.1% 5.0% 6.1% -14.8% 1.9% 3.4%

External Accounts

Merchandise Exports Current (US$ billion) 291.3 216.7 237.3 278.9 209.0 224.2 259.7

Oil Exports (US$ billion) 50.7 29.2 34.7 35.2 26.8 26.9 27.8

Non Oil Exports (US$ billion) 240.7 187.5 202.6 243.6 182.2 197.4 231.9

Merchandise Imports Current (US$ billion) 308.6 229.7 252.0 298.3 215.7 230.7 270.8

Remittances (US$ billion) 25.6 22.1 23.9 26.1 21.2 22.3 23.9

Current Account Balance (US$ billion) -15.8 -13.4 -15.5 -18.4 -7.8 -8.4 -11.5

Current Account Balance (% of GDP) -1.5% -1.5% -1.6% -1.8% -0.9% -0.9% -1.2%

FDI (US$ billion) 22.5 16.9 18.5 22.0 13.5 15.5 19.0

Gross Reserves (US$ billion) 85.4 80.0 81.9 82.0 81.0 80.2 79.2

External Debt (% of GDP) 18.7% 24.8% 24.0% 22.9% 25.5% 25.9% 25.1%

Public Sector

Public Expenditure (%) 4.2% 1.1% 0.0% 5.0% 1.1% -4.3% 3.2%

PSBR Balance (% GDP) -2.1% -2.7% -3.1% -2.8% -2.8% -3.4% -3.1%

Public Sector Debt (% GDP) 35.8% 39.3% 40.1% 40.3% 39.9% 41.6% 42.4%

Prices

Inflation (e.o.p.) (%) 6.5% 4.6% 3.6% 3.3% 5.0% 4.2% 3.6%

Nominal Exchange Rate (pesos/dll) 11.1 13.6 13.5 13.2 13.8 13.8 13.6

Oil Price (US$ per barrel) 86.3 54.4 65.2 66.2 54.4 55.0 57.0

Baseline Low Case

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important increase end-2008 that can be attributed in part to the issue of a recognition bond to public sector workers that opted for the individual savings account in the public sector pension reform. The sharp economic contraction, the depreciation of the currency and a higher fiscal deficit contribute further to an increase of the public debt-to-GDP ratio in 2009. Even though there has been some room for an increase of public debt and the public debt-to-GDP ratio, the rapid increase and level to be attained by the latter by 2010 and 2011 suggests limits to possibilities of fiscal stimulus. In this regard, policymakers face a difficult trade-off between early fiscal consolidation that may aggravate the contraction of the domestic economy and a market reaction (as already expressed by credit rating agencies) that demand a clear and credible medium-term fiscal strategy of revenue-enhancing measures or sustainable spending cuts to compensate for the lower public sector revenue.

16. Debates on the size of the fiscal stimulus and the moment to change toward fiscal consolidation are taking place in many countries and Mexico is no exception. The size of the fiscal buffers going into the recession, projections on the depth and duration of the economic contraction and possible market reactions with respect to increased fiscal deficits and higher levels of public debt are some of the major elements that have to be taken into account in policy decisions on the size and length of fiscal stimulus. Mexico adequately used its fiscal space–created by consistent fiscal policies and falling debt-to-GDP ratios, the accumulation of resources in revenue stabilization funds and the oil price hedge–to enact a substantial fiscal stimulus in 2009 and is currently in the midst of discussing the economic package for 2010.61

17. Public debt remains within manageable proportions despite a significant increase in the debt-to-GDP ratio until 2011. Debt sustainability analysis based on average levels of economic growth, the primary balance and the real interest rate on public debt observed over the decade previous to the current economic crisis and applied to the debt-to-GDP ratios observed in the base and low case scenario by 2011, shows a return to a

61 See Annex 5a for a detailed discussion on fiscal policy and public expenditure management

Figure 4: Mexico Fiscal Sustainability Analysis: Public Sector Debt to GDP ratio, 2005-2016

30%

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44%

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Shock in Growth Rate

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Baseline w. shock

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Combined shock in Growth Rate & Primary Balance

Baseline

Baseline w. shock

Low case

Low case w. shock

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downward path of the debt-to-GDP as of 201262 (figure 4). Bound tests63 with respect to the key growth and primary balance variables show that only in the case of a combined growth and primary balance shock the debt-to-GDP ratio will continue on an upward path and additional corrective policy actions will be needed.

18. The external current account deficit is not a cause of concern. The rapid deterioration of the external financing and economic conditions to the Mexican economy has been rapidly reflected in the country’s exchange rate which led to a rapid adjustment of consumption and investment plans by Mexican households and businesses. This in turn has led to a sharp contraction of imports, in line with or even more pronounced to the fall in exports. The low case scenario provides for a slightly sharper functioning of this adjustment mechanism resulting in an even more modest current account deficit.

62 Values for the variables used in this exercise include: growth average 3.1 percent, standard deviation 2.07 percent; primary balance (adjusted for off-balance expenditure and excluding non-recurrent revenue) average 0.55 percent, standard deviation 0.69 percent; and real interest rate 3.3 percent. 63 Shocks are permanent one-half standard deviation shocks.

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ANNEX 5. ANALYSIS OF THE GOVERNMENT’S ECONOMIC POLICIES Annex 5a. Fiscal Policies and Public Expenditures

Introduction

1. Pro-cyclical fiscal policy has been a stylized fact regarding Mexican—and Latin American--fiscal policy in recent decades. Limited access to finance during downturns often resulted in expenditure cuts that would exacerbate the recession, while political economy constraints often made it difficult to save and reduce public sector indebtedness during boom periods.

2. In the wake of the ongoing global crisis the Mexican authorities have managed to initially increase—and eventually maintain—the level of public expenditure to withstand the sharp contraction in private aggregate demand. Contrary to previous cyclical downturns, the sharp fall in public sector revenue observed in 2009 has not been compensated by a sharp reduction in overall public expenditure or an increase in taxes and, in that way, fiscal policy is allowing automatic stabilizers to function. The fiscal policy response might have been stronger, however, the need for medium-term reforms to reduce the reliance on declining oil revenues have limited the Government’s ability to engage in a more forceful short term response.

3. This annex analyzes fiscal policy as implemented in Mexico in 2009 and proposed for 2010 and the institutional framework that enabled this policy response. It also signals some of the challenges that the current framework of fiscal rules faces in order to enhance the ability to engage in a more countercyclical fiscal policy as well as some other structural limitations of public finance in Mexico.

Background

4. In the years prior to the current global crisis Mexico observed a significant growth of total public sector revenue and expenditure as the public sector managed to expand its participation in the economy by about 2 percentage point of GDP between 2003 and 2008 (table 1). The expansion of the public sector has been driven in part by significantly higher oil revenue as a result of an increase in international oil prices and a historically maximum level of oil production reached in 2004. Oil made up, on average, 36 percent of total public sector revenue, reaffirming the high dependence on oil of Mexican public finances.

5. Efforts to raise non-oil tax revenue during the previous administration were largely focused on improvements in tax administration. In 2007, the Calderón administration implemented changes in tax policy—along with other fiscal reforms--and introduced new taxes which led to an increase of close to 10 percent in the ratio of non-oil tax revenue to GDP in 2008.64 Nevertheless, at less than 10 percent of GDP the tax

64 The new taxes adopted end-2007 are: a flat tax on the value added generated by companies that acts as a minimum income tax (IETU), and a tax on cash deposits in the banking system focused on tax collection from the informal sector (IDE).

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effort in Mexico remains substantially below the level observed in other countries in the region or at a similar stage of development.

6. In addition to a slight decline in the budget deficit in the early part of the period, public expenditure was raised in almost the same proportion as the increase observed in total revenue. A reduction in the total interest cost of public debt relative to GDP created additional space for a more rapid expansion of primary expenditure. A significant part of that expansion took place in capital expenditure including investments in infrastructure and a transfer of part of the oil windfall to revenue stabilization funds (more on this below). At the same time, current expenditure has been expanded.

Table 1: Public Finance, 2003-2008 (as a percent of GDP)

Source: Bank staff estimates based on SHCP and INEG

7. Fiscal policy maintained a strong orientation toward moderation of public deficits and a reduction of the public debt-to-GDP ratio. A balanced budget was essentially achieved as of 2004, i.e. three years before the introduction of a balanced budget rule into the legal budget framework (more on this below). In terms of the Public Sector Borrowing Requirements, a broader concept of the public sector deficit, there was also an important moderation in total public sector deficit spending. This has led to a reduction of the net public sector debt-to-GDP ratio, as reported by the Ministry of Finance under the concept of the Historical Balance of Public Sector Borrowing Requirements, from 38.1 percent in 2003 to 29.9 percent in 2007. The ratio increased subsequently in 2008 to 35.7 percent largely due to the issuance of recognition bonds in the context of public sector workers pension reform.

8. Fiscal policy in Mexico is currently carried out within the framework of a Fiscal Responsibility Law (FRL) that was adopted in 2006. As observed, in the years prior to the adoption of the FRL, moderate public deficit financing and a related reduction in the public debt-to-GDP ratio had already been one of the guiding principles of Mexican fiscal policy. The FRL strengthened and put into a more permanent legal framework some of the macroeconomic stability oriented features of fiscal policy in Mexico that had been evolving in the context of annual budget formulation and discussions in Congress.

2003 2004 2005 2006 2007 2008

Total Revenue 21.2 20.7 21.1 21.8 22.2 23.6

Oil Revenue 7.1 7.4 7.9 8.3 7.9 8.7Non Oil Revenue 14.1 13.2 13.2 13.5 14.3 14.9 o.w. Taxes 9.0 8.4 8.6 9.0 9.3 10.0

Total Expenditure 21.8 20.9 21.2 21.7 22.2 23.7 Primary expenditure 19.1 18.2 18.8 19.1 19.9 21.7

Current 13.5 12.4 12.8 12.9 13.3 13.9 Capital 2.6 3.0 2.9 3.1 3.6 4.4 Tax share local government 3.0 2.8 3.0 3.2 3.0 3.5Budget deficit -0.6 -0.2 -0.1 0.1 0.0 -0.1PSBR -2.4 -0.9 -1.3 -0.8 -1.1 -2.1PSBR excl. non-recurrent revenue -3.0 -2.3 -1.5 -1.1 -1.8 -2.8

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9. In this context the FRL includes:

• Balanced budget rule. The FRL requires budget formulation, approval and implementation to lead to a balanced budget. A budget deficit is only allowed under exceptional circumstances and requires specification of such exceptional circumstances as well as the formulation of a timeframe within which budget balance is restored. The budget includes the federal Government and the state owned enterprises under direct budgetary control, such as the oil company PEMEX, the electricity utilities and social security. The budget does not include a number of off-budget outlays that are included in a broader concept of Public Sector Borrowing Requirements (PSBR). More recently,65 the FRL was amended to bring externally financed investments by PEMEX, which were previously treated as off-budget expenditures,66 onto the budget while at the same time redefining the balanced budget requirement by excluding all investments of PEMEX from the budget balance to be considered.

• Budget reference oil price. As oil makes up a significant part of public sector revenue in Mexico and the international price of oil has been highly volatile, the FRL includes a formula to estimate the oil price as a weighted average of the 10-year moving average of the historical price of oil, the medium term futures oil price as well as the price of oil on the next year’s futures market.

• Distribution of excess oil revenue. The FRL establishes rules to determine the amount of surplus revenue resulting from an oil price that is higher than the estimated budget reference price as well as its distribution among oil revenue stabilization funds. A first oil revenue stabilization fund was established by the federal Government in 2000 while two additional funds, one for investments in the oil sector by PEMEX and another for investments in public infrastructure by state Governments, were added in 2006. According to the law 40 percent of the excess revenue is transferred to the federal Government fund and 25 percent to the PEMEX and States funds each while the remaining 10 percent is transferred to States directly for investment in public infrastructure. The amount of resources that can be accumulated in each of the funds has been capped and once the funds have reached their limit, 75 percent of the excess revenue is allocated to public investment and 25 percent to a fund to support the restructuring of pension systems.

Fiscal stimulus at a time of an unexpectedly sharp revenue shock

10. Preparation, discussion and approval of the budget for 200967 took place at a time of a rapid deterioration of the external economic and financial environment following the bankruptcy of Lehman Brothers mid-September 2008. The fast worsening economic and

65 October 2008 66 Known by its acronym in Spanish as PIDIREGAS. 67 The Mexican budget year coincides with the calendar year

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financial conditions is evident from the change in the macroeconomic assumptions underlying the budget between its proposal early September and approval by Congress in mid-November. From an economic growth of 3 percent, an average exchange rate of 10.6 peso/dollar and an average price for the Mexican mix of oil exports of US$ 80.3 per barrel, these variables were adjusted to 1.8 percent, 11.7 peso/dollar and US$ 70 per barrel respectively.

11. The approved budget would provide a considerable countercyclical fiscal stimulus to economic activity with a 13.2 percent increase, in real terms, in total public expenditure compared to the budget approved for 2008 (see table 2).

Table 2: Approved Budget for 2008 and 2009 (billion pesos)

Source: Bank staff estimates based on SHCP

12. The significant fiscal stimulus suggested by a comparison between the approved budgets for 2008 and 2009 was enabled by a significant increase in oil revenue and an important adjustment to the FRL creating additional fiscal space. Though the price of oil reached unprecedented levels in 2008, the approved budget for that year had been based on an oil price of US$ 49.0 per barrel whereas, as mentioned before, the budget for 2009 was based on an oil price of US$ 70 per barrel.

13. In addition and more relevant from a structural point of view was the amendment to the FRL and the balanced budget rule, referred to before, that brings externally financed investments by PEMEX (PIDIREGAS) onto the budget, while at the same time excluding all investments by PEMEX from the budget balance requirement. As PEMEX finances part of its investment program externally and part with budget allocations, the exclusion of all investment from the balanced budget rule created additional fiscal space estimated at 0.7 percent of GDP for the budget in 2009.

14. Clearly, a more accurate analysis of the fiscal expansion requires a comparison of actual executed expenditures, and it also requires adjustments due to the changing

2008 2009 2009/2008% increase in

real terms

Total Revenue 2,546 2,792 4.7 Oil 866 1,016 12.0 Non-oil 1,680 1,776 0.9Total Expenditure 2,546 3,020 13.2 Programmable 1,900 2,320 16.5

Current 1,509 1,729 9.3 Capital 391 592 44.5 Fysical investment 354 534 44.1 o.w. PEMEX 102 228 113.9 Financial Investment 37 58 47.7 Non programmable 670 725 3.3 Deferred payments -24 -26 3.4Budget Balance 0 -228 n.a.

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definition of budgetary expenditures. As it turns out actual budget execution for 2008 and, as currently programmed, for 2009 modifies the size of the estimated fiscal stimulus. Primarily as a result of a higher oil price, total revenue and expenditure in 2008 were substantially higher than budgeted. Increased expenditure includes a transfer of resources to revenue stabilization funds and, as these funds reached their limit, to a fund for the restructuring of pension systems.

15. More importantly the severe global and domestic economic downturn following the intensification of the global financial crisis in the last quarter of 2008 and in the first quarter of 2009, is leading to a gross revenue shortfall in 2009 compared to the approved annual budget of 478 billion pesos or 4 percent of GDP (see table 3).

Table 3: Budget revenue shortfall and mitigating measures, 2009 (billion pesos)

Source: Bank staff estimates based on SHCP: Criterios Generales de Política Económica 2010

16. The significant fall in both oil and non-oil revenue compared to the originally approved budget can be attributed to a lower oil price, currently estimated at US$ 51 per barrel on average for 2009 compared to the US$ 70 per barrel original budget estimate, a lower level of oil production, at 2,622 thousand barrels per day instead of 2,750 thousand, and a contraction of the domestic economy, estimated at 6.8 percent, instead of a GDP growth of 1.8 percent.

17. The gross revenue reduction led to an automatic reduction in the tax revenue shared with lower levels of government, thus creating a net shortfall of 428 billion pesos. The Government proposes to cover this amount with a transfer of profits from the central bank, receipts from an oil hedge contracted by mid-2008 and withdrawals from the Government’s oil revenue stabilization funds as well as by reducing public expenditure by 85 billion pesos. In addition, the cost of PEMEX’ investment program increases by 24 billion pesos largely attributable to a weaker peso though this increase does not require to be compensated under the recently amended balanced budget rule and is reflected in a higher budget deficit.

18. An initial comparison between the budget implemented in 2008 and the year-end budget estimates for 2009 suggests that the public sector has been able to maintain the nominal level of expenditure (table 4). A more complete assessment of the spending impulse requires some adjustments to the expenditure accounts in order to make the

Approved

B d t

Estimated impact

R

Estimated

B d tTransfer profit

Central Bank

Oil hedge and

Stabilization fund

withdrawal

Expenditure

adjustment

Total Revenue 2,792 -478 95 248 2,658 Oil 1,016 -229 787 Non-oil 1,776 -249 95 248 1,870Total Expenditure 3,020 -26 -85 2,908 Programmable 2,320 24 -85 2,259

Non programmable 725 -50 675 Deferred payments -26 -26Budget Balance -228 -451 95 248 85 -251

Revenue and Expenditure measures

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economic impact of the expenditure between 2008 and 2009 fully comparable. Such adjustments include: adding the externally financed investment by PEMEX in the budget spending for 2008 and subtracting the transfers to stabilization funds in 2008 as these are a financial saving rather than expenditure. Estimates presented by SHCP, incorporating such adjustments, show that public spending maintained its level in real terms between 2008 and 2009.68

Table 4: Implemented Budget 2008 and 2009 (billion pesos)

2008 2009

Implemented Estimated

Total Revenue 2861 2658

Oil 1055 787

Non-oil 1806 1870Total Expenditure 2872 2909

Programmable 2229 2259

Non programmable 666 676

Deferred payments -23 -26

Budget Balance -11 -251 Source: Bank staff estimates based on SHCP: Cuenta de la Hacienda

Pública Federal 2008 & Criterios Generales de Política Económica 2010

19. To provide support to economic activity when most needed the Government front loaded its public expenditure and investment programs in 2009. As a result, current expenditure and public sector induced physical investment69 increased by 5.4 and 27.7 percent, in real terms, respectively during the first half of 2009 compared to the same period of the previous year. .

20. The impact of front loading public expenditure in the first half of 2009 as well as of increased spending observed during the second half of 2008 on aggregate demand can be observed figure 1. The figure presents the contribution to the growth in aggregate demand (year-on-year) according to the main categories of demand identified in the national account statistics. From the third quarter of 2008 up until the second quarter of 2009, public expenditure had a significant positive contribution to economic activity; however, it was clearly unable to compensate for the dramatic reduction in private consumption and investment. Even though the collapse of trade played an important role in the overall contraction, the figure shows a positive contribution of net foreign demand which is a reflection of an even sharper contraction of imports than the reduction of exports.

68 SHCP Criterios Generales de Política Económica 2010 page 88 69 Consists of on budget physical capital investment and off budget financed physical capital investment (PIDIREGAS)

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Figure 1: Contribution to Growth (year-on-year)

Source: Bank staff estimates based on National Account Statistics, INEG

The 2010 budget: Addressing the transitory and permanent revenue shock

21. On September 8th the Government sent its proposed fiscal package for 2010 to Congress. The package consists of a revenue law, an expenditure decree and a document describing the macroeconomic situation and main assumptions underlying the proposed fiscal policy.

22. The main macroeconomic assumption on which the budget estimates and proposed policy measures are based include an economic growth for 2010 of 3.0 percent, an average oil price for the Mexican mix of oil exports of US$ 53.9 per barrel and reduction in the volume of oil production to 2,500 thousand barrels per day. On the basis of these assumptions and an update of the 2009 budget implementation, the Government estimates a shortfall in revenue in 2010, compared to the budget approved for 2009, of 374 billion pesos (2.9 percent of GDP). This shortfall is divided into a temporary or transitory (tax) revenue shortfall attributed to a level of economic activity below potential output and a more permanent or structural component due to a reduction in the volume of oil production (see table 5).

23. The Government proposes to cover the transitory shortfall to an amount of 155 billion pesos with non-recurrent revenue, 95 billion pesos, and additional deficit financing, 60 billion pesos. The latter implies invoking, for the first time since its adoption, a clause in the fiscal responsibility law that allows for a temporary deviation from the balanced budget rule under extraordinary conditions.

24. The Government strategy to cope with the revenue shortfall is based on maintaining the level of programmable expenditure (excluding PEMEX investments) in 2010 similar, in real terms, to the level estimated by the end of 2009. For the years thereafter the Government envisages to keep a constant expenditure to GDP ratio, thus

-15.0%

-13.5%

-12.0%

-10.5%

-9.0%

-7.5%

-6.0%

-4.5%

-3.0%

-1.5%

0.0%

1.5%

3.0%

4.5%

6.0%

04:I

04:II

04:III

04:IV 05

:I

05:II

05:III

05:IV 06

:I

06:II

06:III

06:IV 07

:I

07:II

07:III

07:IV 08

:I

08:II

08:III

08:IV 09

:I

09:II

Private Consumption

Private Investment

Public Expenditure

Foreign Balance

GDP

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allowing for expenditure growth, in real terms, similar to the growth of economic activity. Based on an expected return of the economy to its estimated longer term potential output growth of 4.2 percent by 2012 and the income generating capacity of a series of public revenue enhancing measures the Government foresees the need for temporary deficit financing, attributed to a slack in economic activity, for a two-year period, 2010 and 2011, while returning to a balanced budget by 2012.

Table 5: Public Finance Policy Measures 2010 (billion pesos)

Source: Ministry of Finance General Criteria for Economic Policy, 2010

25. To cover the structural component of the revenue shortfall in 2010, 219 billion pesos, the Government proposes a series of public revenue enhancing measures to an amount of 176 billion pesos.

26. Public revenue enhancing measures aim to broaden the tax base and are oriented to enhance non-oil revenue through changes in the regime for excise taxes, income taxes and the introduction of a new consumption based contribution. Proposed adjustments in the area of excise taxes include the introduction of an excise tax on the use of telecommunication services and an increase of the excise tax rate on tobacco, lotteries, beer and alcoholic beverages. Modifications to the income tax regime include a temporary increase of the top income tax rate from 28 to 30 percent for 2010 to 2012 and gradually reducing the rate to 29 percent by 2013 and back to 28 percent by 2014. The tax on cash deposits in the banking system (that was introduced in the 2007 tax reform to capture revenue from the informal sector as the tax is creditable against the income tax) will be increased from 2 to 3 percent while the threshold for exempt deposits is lowered from 25,000 (about 15 minimum wages) to 15,000 pesos (about 9 minimum wages).

27. The Government is also proposing to introduce a new tax, called the “contribution to reduce poverty”, on the consumption of all goods and services at a rate of 2 percent. The Government expects to collect revenues of 72 billion pesos (0.6 percent of GDP) from this tax in 2010 and these resources will be allocated, on a priority basis, to poverty reduction programs—in particular conditional cash transfers and social protection programs. Among the actions included in the Government program for 2010 that will be supported by the adoption of the contribution are an increase in the budget allocation for the Oportunidades and Food Support cash transfer programs by 31.5 billion pesos to a total budget allocation for 2010 of 81.1 billion pesos in order to expand coverage to at least 6.5 million families.

Total 374 Total 374Transitory component 155 Transitory measures 155

Public Deficit 60 Non-recurrent revenue 95

Permanent component 219 Permanent measures 219 Revenue enhancing measures 175.7 Net reduction programmable spending 74.2 Net increase non-programmable spending -30.9

Revenue shortfall compared to 2009 Compensating measures

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28. The proposed budget also includes a gradual increase in prices of publicly supplied goods and services (largely electricity rates and gasoline prices), though does not specify the exact amount of these increases. As these prices can be set by the Government without an explicit approval by Congress, the Government may adjust the increase following the outcome of budget discussion with Congress.

29. Among the measures to close the permanent revenue shortfall, the Government proposes a cut in programmable spending, 74 billion pesos or 0.6 percent of GDP. In addition, a reallocation of programmable expenditure is required to create space within the budget for increased pension payments and an expansion of the poverty reduction and health coverage programs to an amount of 144 billion pesos. Both efforts demand a gross reduction of 218 billion pesos in existing structures and programs of the federal public administration. In addition to streamlining the public administration and a reduction of operational and payroll expenditures, the Government plans to concentrate resources on programs that are better aligned to the priorities of national development and on projects and programs that have demonstrated better results and evaluations. Efforts to improve the performance monitoring and evaluation capacity within the public administration over the past few years are being used to guide this reduction and reallocation of expenditure. This is discussed in greater detail below.

Medium term challenges to enhance fiscal rules and strengthen non-oil revenue

30. The global financial crisis and its consequences on world economic activity and trade have been transmitted to the Mexican economy and its public finances through several channels. In this regard, fiscal policy in Mexico is formulated and implemented in the face of three major revenue shocks: one due to a collapse of oil prices, a second as a result of a sharp contraction of economic activity and the related drop in tax collection, and a third related to an unexpectedly rapid reduction in the volume of oil production. The first two of these shocks are related to the business cycle whereas the third is of a more structural nature.

31. The first two cyclically related shocks are being addressed through a set of fiscal rules that are used to smooth public spending and reduce the pro-cyclical bias of fiscal policy in Mexico, even though the exceptionally strong economic downturn in 2009 is showing some of the limitations in the existing framework.

32. The mechanism in the FRL to limit the impact on public spending of volatile oil revenue as a result of the oil price volatility consists of two basic features: (a) a formula to set the budget reference price for oil and (b) rules for the distribution of excess revenue among different revenue stabilization funds and public investments.

33. Until recently oil price forecasts used in Mexican budgets have been conservative compared to actual prices (Figure 2). The formula that is used as of 2006 to set the budget reference price of oil is based on a weighted average of the 10-year moving average of the historical price of oil, the medium term futures oil price as well as the price of oil on the next year’s futures market. The weights given to each of these prices,

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25, 25 and 50 percent respectively tends to bias the reference price towards the prevailing market price (OECD 2009).

Figure 2: Oil Price

Source: SHCP and PEMEX

34. As elaborated further below, the combination of a budget reference price and the use of (capped) stabilization funds as currently in place in Mexico protects public spending during a budget year from a sharp fall in oil prices compared to the budget reference price. It does not avoid the need for sharp fiscal adjustments in case of reductions in the oil price beyond one year as currently observed in the budget process for 2010. The reference price for oil in the proposed 2010 budget is 23 percent below the reference price in 2009. A stronger smoothing of the inflow of oil resources into the economy and public finance may require some further adjustments to the formula of determining the budget reference price or the use of alternative institutional arrangements such as independent expert panels as in the case of Chile.

35. The institutional framework of setting a budget reference price should be complemented with rules on the distribution of excess revenue and the creation of oil stabilization funds. In principle, oil revenues that exceed the annual set reference price would be transferred to the funds. However, despite a consistently higher actual price of oil than the budget reference price up to and including 2008, savings accumulated in the stabilization funds stood at 145 billion pesos or 1.2 percent of GDP at the end of 2008. The limited accumulation of savings in the stabilization funds can be attributed to deductions from the excess oil revenues to compensate other revenue shortfalls or higher-than budgeted expenditures in specific categories of the budget and, more importantly, to low caps established on the accumulation of resources in each of the funds. After reaching the cap, as in 2008, further excess revenue is allocated to additional public investment and transferred to a fund for the restructuring of pension systems.

36. Caps on the accumulation of funds in the stabilization funds were almost doubled in the amendments to the FRL in November 2008. Nevertheless, they remain remarkably low compared to the challenge of reducing impact of volatility of oil prices on budget spending. The Government is proposing to lift the limit on the accumulation of savings

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in the funds for 2010; though a more permanent action to raise the caps substantially or lift them altogether would seem appropriate.

37. Despite the limited accumulation of savings in the stabilization funds, the Government successfully averted the negative impact of the collapse of oil prices (late 2008 and early 2009) on the budget in 2009. It was able to do so as it had contracted mid-2008 oil price hedges for estimated net exports at the average budget price of 70 dollar per barrel, using resources from the federal Government’s stabilization fund to purchase the hedges. Thus it was able to offset the impact on the budget from a drop in the oil price below the level estimated in the budget by leveraging the resources available in the stabilization fund. Employment of such additional risk management instruments should be encouraged though are no substitute for raising of the limits on the stabilization funds.

38. Another pillar of the FRL consists of the balanced budget rule. Rather than encouraging a smoothing of public spending or countercyclical fiscal policies, the aim of the balanced budget rule is to ensure fiscal sustainability. The rule itself has a bias towards pro-cyclical fiscal policy as larger revenues during the upside of a cycle would tend to be spent at the time they are collected (OECD 2009). Only the escape clause that allows for additional deficit spending under exceptional social or economic conditions, as proposed to be applied in 2010 and 2011, may reduce some of the pro-cyclicality of the rule. The framework of the FRL does not establish a methodology to determine the amount of deficit spending that can be incurred, nor does it establish to need to compensate for deficit spending in bad times with the creation of a fiscal surplus in good times. In this regard the FRL framework could benefit from the introduction of a cyclically adjusted or structural budget balance rule.

39. A decline in oil production from a record high in 2004 has been observed now for a couple of years already (Figure 3) and can hardly be referred to as a shock. A tax reform introduced in 2007 was aimed at broadening the non-oil tax base to start compensating for a projected decline in oil production. Nevertheless, the recent decline in oil production has been much steeper than anticipated. Over the past two years the Government included production and export estimates in the budget documents between 100-200 thousand barrels per day above the levels of production actually attained. Current Government estimates point at a stabilization of the levels of production at 2,500 thousand barrels per day between 2010 and 2015, though these estimates are surrounded by a large margin of uncertainty. Increasing non-oil tax revenue, from a level as low as 10 percent of GDP, by broadening the tax base, reducing exemptions and improving tax collection thus remains a high priority in order to reduce the dependence of Mexico’s public finance on highly uncertain and exhaustible oil revenues.

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Figure 3: Oil Production, Exports and Imports

Source: SHCP and PEMEX

Public expenditure management to support fiscal policy efficiency and effectiveness

40. Over the last decade the Government has made substantial progress in public sector management reforms to produce a more efficient and effective public administration. The Government improved its budgetary discipline by strengthening fiscal planning and accountability to ensure compliance with revenue and expenditure management rules throughout the public sector.

41. The administration of President Calderon has framed its efforts to enhance the efficiency, effectiveness and accountability of public spending in an expenditure performance evaluation system, the Sistema de Evaluación del Desempeño (SED) which establishes methodologies and policies on performance informed management and performance informed budgeting.

42. The overall objective of performance-informed budgeting (PIB) is to strengthen the quality of public expenditures by improving the allocation, efficient use and consistency of public resources in alignment with social and political priorities and goals. Performance informed budgeting has also been designed to promote public sector responsiveness and accountability to Congress and the public alike. The intermediate objective is make performance information available to decision makers in a manner that allows them to link it, albeit generally loosely, to planning and managerial actions so that decisions are informed by performance measurements in addition to other sources of information such as experience, qualitative information and political priorities.

43. There are a number of necessary precursors to the successful implementation of performance informed budgeting and the effective use of performance information in the budget process. These include the development of program budgeting and the use of medium term expenditure frameworks. The Government of Mexico has decided to prioritize the implementation of these precursors by establishing a foundation to ensure

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overall accountability and compliance with public financial management requirements at all three levels of government.

44. In this respect, a Governmental Accounting Law was enacted on December 31, 2008 to establish accrual accounting and harmonization of the accounting standards among the three levels of government (federal, state and municipal). The law has an implementation horizon of three years and by 2012 the accounting norms, standards and practices at all levels of governments should be harmonized and able to issue information in real time.

45. During the first year of implementation of the law the following actions were completed:

i. Creation and installation of the National Council for Accounting Harmonization and the Consultation Committee, both with their internal norms and regulations.

ii. Development of the Conceptual Framework of the Governmental Accounting, Fundamentals of the Governmental Accounting and Norms and Methodologies for the Determination of the Expenditure Accounting Moments.

46. Further steps to implement the mandates of the law include: i. Harmonized budgetary classificatory

ii. Norms and Methodologies for the Determination of the Income Accounting Moments.

iii. Structure of the basic financial statements iv. Guidelines for the physical-financial progress indicators (link to Federal public

resources) v. Main rules to register and value public goods

vi. Structure of accounting catalogs and accounting manuals

47. The challenge to implement the Governmental Accounting Law within all the three levels of government will depend on an adequate coordination across these levels of government.

48. Other actions carried out to date at the level of the Federal Government to further the adoption and implementation of the SED includes:

i. Adaption of the budgetary framework to identify the final use of public spending as well as link spending to strategic planning objectives for national development;

ii. Institutionalization of new methods to define objectives, performance indicators and targets for the federal programs with the purpose to gradually incorporate performance information in budgetary decisions.

iii. Development of IT systems to follow up targets established in the programs that integrate The Budget Law for the Federal Government

iv. Definition and operation of mechanisms for all program evaluations established in the Annual Evaluation Program and to follow up the corresponding program improvement recommendations.

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49. Specific progress in the implementation of the SED as reflected in the 2010 budget proposal includes:

i. Alignment of the budgetary process to performance information across the budget cycle (Planning, Programming, Budgeting, Execution, Monitoring, Evaluation and Accountability).

ii. Adjustment of the budgetary structure to integrate performance information. A specific module was created in order to reflect the alignment of the Federal Programs to sectoral strategic objectives and to the National Development Plan objectives.

iii. Progress in the Indicators Results Matrices. Currently 58.7 percent of the budgetary programs integrate performance information and the target for 2012 is to increase this to 72.5 percent, whereas 11.6 percent of the budgetary programs have been evaluated in accordance with the criteria established in the annual evaluation program and the target is to increase this figure to 16.5 % by the end of 2012.

50. Consolidation of the performance informed budgeting at the federal level will continue through the end of the current administration. Implementation of the SED, at the different levels of Government, will require substantial coordination with the subnational levels. States have initiated the process by establishing the corresponding legal framework in terms of budget, expenditure and accounting. Some of them have already approved the decree for the creation of the evaluations units and advanced the formulation of performance indicators.

51. The states’ initiatives will be strengthened during 2010 particularly due to some specific requirements of the General Accounting Law in terms of physical and financial indicators. These efforts will build upon the progress achieved by the Federal Government in the definition of specific methodologies to measure results that will be very useful in a context of a harmonized framework for the programmatic budget information.

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Annex 5b. Financial Sector Policies

Introduction

1. Mexico´s financial sector appears sound and well supervised, but remains underdeveloped relative to other high-middle income countries. In addition, the global financial turbulence has had a substantial impact on Mexico´s financial markets and financing alternatives for Mexican companies. For more than a decade, financial sector policy has featured prominently in Mexico’s development agenda with the dual objective of promoting stability with access. Competition and access to finance gained greater prominence as stability strengthened. In the wake of the global financial crisis, Mexico´s government has moved quickly to mitigate new risks and stepped up financing support by development finance institutions to prevent a sharp credit contraction that could further weaken economic activity.

Financial system overview and impact of the global financial turbulence

2. Financial and capital markets in Mexico remain underdeveloped relative to the size of the economy. Financial depth indicators compare unfavorably with both global and regional indicators. The banking sector is broadly half of the size of those in Brazil and Chile, and similar in size to the banking sectors in Colombia and Peru70. At end March-2009, total private domestic credit stood at only 26.8 percent of GDP. Only 8 percent of total domestic funding is provided by the issuance of securities in the local capital markets, mostly in the bond market.

3. Despite limited financial depth, Mexico’s financial system is diverse, comprising banks, non-bank credit institutions and other financial institutions About 60 percent of domestic credit is extended by domestic commercial banks compared to 32 percent by other non-bank credit institutions and development banks. The banking system is concentrated and mostly foreign; the 6 largest banks hold more than 80 of the assets while foreign banks hold about 75 percent of commercial bank assets. Development banks play a large role in

70 Commercial banks’ assets amount to 86 percent of GDP in Brazil, 112 percent in Chile, and about 40 percent both in Colombia and Peru.

Table 1. Mexico. Overview of Financial System. Assets to GDP as of December 2008

Banks

Commercial banks*** 45.0%

Development banks 6.7%

Non-bank credit institutions

SOFOLES 1.3%

Infonavit 4.5%

Other* 0.6%

Other financial institutions

Mutual funds*** 6.6%

Insurance*** 5.1%

Economic development funds 1.5%

Brokerage house 1.8%

Pension funds*** 9.4%

Other** 0.2%

*Other includes leasing and factoring firms, savings and loans associations, credit unions and deposit warehouses

**Other includes money exchange and afianzadoras

***Data refers to April 2009

Source: Banco de Mexico

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sectors that have traditionally lacked adequate access to financial services � SMEs, small producers in rural areas, infrastructure and housing sectors � and had assets of 6.7 percent of GDP as of end 2008. Mutual funds, insurance companies and pension funds have grown in the past years, especially mandatory pensions, but remain relatively small with assets comprising about 20% of GDP (table 1).

4. Non-bank credit institutions include leasing and factoring firms, credit unions, and savings and loan associations, and Sofoles. Sofoles (sociedades financieras de objeto limitado) and Sofomes (sociedades financieras de objeto múltiple) are the largest institutions in the sector and raise funds through capital markets or bank borrowing but are not allowed to take deposits. They offer credit to consumers, SMEs, real estate developers and home buyers and have played a particularly important role in the mortgage sector.

Table 2: Credit to Non-bank Private Sector (Million pesos in constant prices)

Source: Banxico

5. Total credit to private non-bank sector increased at double digit rates until mid-2008 before the global turbulence heightened (Table 2). Consumer credit increased the fastest, led by the credit card business, accounting for 25 percent of total bank credit to the private sector by mid-2008 (Figure 1). External credit also increased accounting for about a fourth of total credit to the non-financial private sector (Table 2).

Figure 1. Credit to non-bank private sector (Billion pesos, in constant prices)

Source: Banxico

Figure 2. Deposit, Lending and Policy Interest Rates

Source: Banxico

constant prices Total Funding Total External funding Direct debt issues Total Internal funding Comm. Bank Dev. Banks NBFI debt issues Infonavit

Dec-05 2,255,306 568,394 362,760 205,634 1,762,014 860,228 48,940 257,674 166,152 429,020 Dec-06 2,685,634 690,746 480,523 210,222 2,103,657 1,134,434 51,888 264,674 175,837 476,825 Dec-07 3,091,674 736,474 488,742 247,732 2,471,447 1,459,259 50,412 240,818 187,779 533,178 Jun-08 3,183,259 716,144 489,088 227,056 2,634,554 1,464,424 50,605 334,729 214,611 570,186 Sep-08 3,336,338 803,335 565,808 237,527 2,715,501 1,460,998 51,645 392,571 229,049 581,239 Dec-08 3,484,591 967,019 690,675 276,344 2,745,116 1,522,957 69,371 344,775 222,244 585,770 Mar-09 3,526,797 956,604 687,817 268,786 2,783,212 1,526,917 74,529 335,021 221,063 625,683 Jun-09 3,434,728 869,995 617,620 252,375 2,761,886 1,499,613 79,594 327,691 223,976 631,013

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6. Notwithstanding the above, many market segments remain underserved. Recent surveys suggest that the percentage of the adult population with access to financial services ranges from 45 percent to 60 percent. Many small and medium enterprises (SMEs) continue to face difficulties in accessing finance, and availability of long-term finance is scant, and most commercial bank lending tends to be short-term and costly given high interest rates and commission charges. In addition, compensatory balances are usually required to gain financing from Mexico’s largest banks, with balance requirements above 30 percent for SMEs. Uncertainty about the foreclosure process under Mexican law means that lenders demand conservative collateral ratios or simply do not consider weaker or smaller companies. By contrast, Mexico’s large corporations face a greater number of options, including access to domestic capital markets and external financing (43 percent of total private corporate financial debt is external).

Impact of the International Financial Crisis

7. The global financial turbulence at end-September 2008 had, as elsewhere, significant effects on the Mexican financial markets. The deepening of the financial crisis after the collapse of Lehman Brothers had two main effects: increased risk aversion prompted investors to find more secure assets, and financial institutions embarked on a deleveraging process, liquidating positions in several markets. Emerging countries--among them Mexico--were particularly affected: spreads increased on sovereign and corporate debt and exchange rates depreciated and became more volatile (See Figures 2(a-f) in Annex 4). As in other Latin American countries, the stock market experienced a sharp fall (Figure 3).

8. The financial markets turmoil has had a considerable impact on financing alternatives for Mexican companies. Institutional investors shifted towards safer assets and shortened the duration on their portfolios by selling longer-term assets, including

Figure 3. Evolution of Stock Market Indices for Brazil, Colombia and Mexico

Source: Bloomberg

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government bonds. Speculative derivative positions by several large Mexican corporations caused unexpected commercial paper defaults as the peso depreciated, damaging investors’ confidence in the credit quality of local issuers, which experienced difficulties in rolling-over maturing securities. The uncertainty caused by this event and the global turmoil further increased risk aversion in domestic markets, and the Government had to step in to facilitate the refinancing of corporate debt and to prevent a collapse of the nascent mortgage backed security market (Section IV). Issuance of domestic corporate bonds with maturities beyond one year declined by 87 percent in the last quarter of 2008 and, during the first half of 2009, amounted to half the value issued during the same period in 2008.

9. Large companies are also finding fewer opportunities to issue debt abroad and costs are substantially higher. In the first quarter of 2009, external issuances decreased by 15 percent. The cost of issuance in external markets experienced an average annual increase of 570 basis points in 2008, reaching 1,200 points above the five-year US Treasury bond rate at year-end. By April 2009, the spread had declined to about 800 basis points but was about 4 times higher than prior to the crisis. Against this backdrop, large corporations have turned to domestic banks for funding.

10. Credit growth by domestic commercial banks virtually halted and decreased in real terms in the second quarter of 2009. Commercial bank credit during the first half of 2009 was largely flat in real terms during the first half of the years versus compared to almost double digit growth a year earlier, despite the reversal in the monetary policy stance (Annex 2). Consumer credit has been most affected contracting by about 21 percent in real terms at the end of June 2009 compared to a year earlier. Interest rates increased in the second half of 2008 due to constrained liquidity and the increased risk of default of debtors. Although the expansive monetary policy brought down the TIEE by 375 basis point, average commercial loan rates have only declined by about 100 basis points and stood at around 11 percent during the first half of 2009.

11. Tighter credit conditions have made it harder for SMEs to secure bank financing as large companies have resorted to domestic bank borrowing. The results of a Banco de México survey conducted in the fourth quarter of 2008 indicated that about ¾ of survey participants did not seek commercial bank credit. The primary reasons were higher interest rates (49.8%), more restrictive lending conditions (44.8%), and deteriorating economic conditions (37.5%). SMEs have been particularly affected since they now have to compete with companies that formerly financed themselves abroad or in the domestic capital markets. This is illustrated by the fact that the proportion of the loan portfolio owed by the largest debtors has increased noticeably71. Loan maturities have also declined. About 32 percent of the peso-denominated bank credit to enterprises had maturities exceeding 90 days during the period October 2008-May 2009 compared to 40 percent during the first quarters of 2008.

71 About 70 percent of the commercial loans granted by the 6th largest banks is owed by 1 percent of debtors at end-May 2009 compared to 60 percent at end-September 2008.

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In order to mitigate the effects of the global financial turbulence and prevent a collapse in credit, the Central Bank eased monetary policy (see Annex 2) and the Ministry of Finance supported the expansion of the balance sheet of development banks in a counter-cyclical fashion as discussed in the next section.

Risks to the financial system

12. Although current economic conditions heighten existing vulnerabilities, Mexico’s financial system appears sound and it is well supervised. To a large degree, this results from public efforts implemented for more than a decade to enhance the legal and regulatory framework and strengthen capacity to supervise the system. The main risks to the financial sector arise from commercial banks, which dominate the system (Table 1). Mexican commercial banks are currently well capitalized with capital adequacy ratios above the required minimum (16.2 percent at the end of June 2009) and could withstand further deterioration in their portfolios. Stress tests conducted by the CNBV72 indicate that the solvency ratio for the banking system would remain well above the minimum regulatory level of 8 percent. Some small banks, however, may have to increase capital or merge with other stronger institutions. Nevetheless, the increase in loan loss provisions is likely to impact their profitability. Return on equity went down from 21.1% in March 2008 to 11.2% in March 2009. Some of the medium and small banks exhibit great concentration in their sources of funding.73

Table 3. Mexico. Banking Sector Performance

Non-performing loans Coverage June 2008 June 2009 June 2008 June 2009

Commercial 1.1% 2.0% 290.9% 194.6%

Consumer 7.0% 9.5% 104.1% 105.9%

Mortgage 3.1% 4.3% 130.6% 91.6%

Total 2.8% 3.8% 160.2% 143.6%

Source: CNBV

13. The deterioration of the loan portfolio in the event of a severe economic downturn poses the main risk to the financial system. Non-performing loans for the total banking system were 3.8 percent in June 2009 versus 2.8 percent a year earlier (Table 3). The fastest and strongest deterioration has been in consumer portfolios with average non-performing loans of 9.5 percent of total loans as of June 2009 (7.0 percent in June 2008). The CNBV has issued a new regulation modifying provision requirements for consumer credits, using a prospective methodology that is better aligned to the Basel II framework regarding expected losses. Amendments in the methodology include inter alia new

72 The Comisión Nacional Bancaria y de Valores is responsable for supervising commercial banks and securities markets. 73 At end-March 2009 the ratio of liquid assets and assets maturing in 30 days to liabilities potentially due in 30 days stood at about 200 percent, although there was wide disparity among banks, with some of them (including one of the largest 6 banks) having a ratio below 100 percent.

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parameters to determine the probability of default and measure expected losses within a 12-month period. The request of authorization to the CNBV for the use of internal models will be allowed.

14. The rate of non-performing loans in the commercial portfolio at the end-of-June 2009 was 2.0% but is likely to increase further as indicated by the number of credit rating downgrades experienced by Mexican corporations during the year and the substantial concentration of banks´ commercial portfolio in large firms. The 281 largest debtors represent 50 percent of commercial banks´ credit in this segment. The downgrades are limiting firms´ capacities to refinance their debt which could in turn result in defaults.

15. Non-bank financial institutions are relatively small and unlikely to pose systemic instability. Nevertheless some concerns persist regarding the health of some Sofoles and Sofomes. The market for mortgage back securities, which had become an important source of funding for Sofoles dried up at the end of 2008, and 2009 issues have been scarce. Sofoles had difficulties in refinancing their debt, and two defaulted on their debt in spring 2009. Guarantees by Sociedad Hipotecaria Federal (SHF) may have solved the liquidity problems of the Sofoles in the near term, but there are concerns over the quality of their portfolios. NPLs loans for the Sofoles surged to 7.5 percent in March 2009 from 3.8 percent in March 2008. Coverage rates have decreased and are much lower than for commercial banks (43 percent in March 2009 versus 159 percent for commercial banks). This could impact the Sofoles’ solvency, with a capital-to-asset ratio of 10.6 percent as of March 2009. The Government is working with Congress on legal reform proposal to enhance the prudential and supervisory framework that applies to the Sofoles and Sofomes.

Financial Sector Policy Interventions to Foster Stability and Access

16. Financial sector policy has had a prominent role in Mexico’s development agenda with the dual objective of promoting stability and access to finance to support growth and improve the living standards of the population. Early on, there was a greater policy focus on financial stability. As the financial system became more resilient, policy attention increasingly turned toward issues of competition and access without losing sight of the importance of stability. The National Development Plan of 2007-2012 reconfirmed the importance of broadening access without threatening stability. Overall the Government has supported the objectives of stability, competition and access through a multi-pronged strategy that encompasses improvements to the regulatory framework, a strengthening of institutions responsible for financial markets oversight, and pro-active market access policies through development finance institutions (DFIs). The last has been accompanied by substantial improvements to the governance and institutional structure of DFIs.

Legal and Regulatory Changes to Strengthen Stability and Access

17. Overall, the regulatory and institutional framework for financial markets and their oversight has strengthened substantially during the current decade. A summary of the main legal and regulatory changes implemented to promote stability and foster greater market access and diversification of financing follows.

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Strengthening Prudential Regulations and Market Transparency • Issuance of regulatory accounting standards in accordance with international

accounting standards. (FSAP update 2006) • Issuance of regulations by the National Banking and Securities Commission (CNBV)

to strengthen prudential requirements and risk management in the banking sector that cover inter alia (i) capital adequacy-based early warning indicators to trigger prompt corrective action; (ii) standards for external auditors and credit institutions in relation to the provision of external auditing services; and (iii) corporate governance requirements for integrated risk management of credit institutions.

• Amendments to the Law of Credit Institutions (2004 and 2006) strengthening the framework for bank resolution. The first reform provides a modern system of early warnings and prompt corrective actions. The second reform provides cessation of payments as a trigger for bank resolution; provides for information exchange between relevant agencies; defines flexible options for closed-bank resolution based on the least cost criteria; and protects supervisors discharging their duties in good faith.

• Issuance by CNBV of regulations to enhance market disclosure and transparency that cover inter alia financial reporting requirements for financial group holding companies that are subject to supervision by CNBV and harmonize the disclosure of financial information by credit institutions.

• Enactment of a new Securities Markets Law (2005) that enhances governance by establishing inter alia the role and duties of the management and boards of listed companies and applicable sanctions (2005).

Increasing Access, and Diversification of Financing and Investment Instruments

• Enactment of a legal framework to regulate Credit Information Bureaus (2001) that broadened the universe of participating lenders, improved data timeliness, and strengthened the protection of personal data.

• Enactment of a new Securities Market Law (2005) that enhances access to capital markets by inter alia creating new corporate vehicles to facilitate stock market listing

• Amendments to the Pension System Laws in 2003 and 2007 increasing the number of pension funds that pension firms can manage from one to two and five, respectively, and expending the universe of instruments and assets classes that pension funds can invest in. These reforms have expanded financing sources for the private sector and, more importantly, have provided participants in the system with a wider set of portfolios to choose from according to their risk preferences and age.

Enhancing Consumer Protection

• Enactment of the Law on Transparency and Ordering of Financial Services (2004 and 2007) that prohibited discriminatory practices between credit institutions and users; established transparency requirements in check account balances, credit and debit cards, and other credit instruments; and established transparent mechanisms to permit users of credit institutions to know about the value and fee of transactions. Broadly speaking, it entrusted CNBV with the regulation and supervision of marketing practices and issuance of general criteria on financial contracts offered by

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regulated credit institutions to foster adequate services to consumers, and provided the National Commission for the Protection and Defense of Consumers of Financial Services (CONDUSEF) with similar criteria on non-regulated SOFOMEs.

In parallel to the aforementioned legal and regulatory changes, the Government continued its efforts to enhance the capacity of agencies responsible for the oversight of financial market institutions. As a result, oversight has greatly improved.

Fostering Access through Development Finance Institutions

18. Substantial legal and institutional changes have taken place during the decade in order to enhance the role and effectiveness of DFIs in facilitating the delivery of financial services to underserved markets. The literature’s thinking on development banks has evolved over the last half century (Box 1), and to a large degree, the transformation of Mexican policy towards development banks during this decade reflects the latest thinking on development finance or the agency view. The latter recognizes that DFIs can be an important channel to address market failures and respond to social mandates as long as their interventions do not conflict with long-term market development (De la Torre, Gozzi and Schmuckler 2006). Such interventions, however, do not come without challenges. DFIs can be prone to resource misallocation (Banerjee 1997) unless a good governance framework and the operational flexibility are in place to allow for independent and professional management. Furthermore, DFIs can often face a tension between their public policy mandate, which may require subsidies to reach the targeted population, and the need to show a sound financial performance (De la Torre et al. 2006), thus arguing for a clear separation of subsidies from financing (Box 1).

19. Broadly speaking, the reform of DFIs in Mexico has taken into account the concerns and guiding principles provided in the DFI literature, but the pace of transformation has changed across institutions. Overall, an important rationalization of DFIs has occurred during this decade resulting in a reduction in the number of DFIs from [12] to six through mergers and the closure of poorly performing institutions. For the most part, the focus has changed from first tier (direct financing) to second tier financing through other market intermediaries. The six DFIs broadly support the development of different financial market segments (productive sector, trade finance, infrastructure finance, rural finance, and housing finance), but there is some degree of overlap in a few cases. The legal mandates of the recently created DFIs (Sociedad Hipotecaria Federal, Bansefi and Financiera Rural), which were created in the early 2000s, incorporate the new thinking on development finance and tend to be more precise compared to the mandates of Nafin, Bancomext, and Banobras with a far longer history.

20. In 2002, the Credit Institutions Law and the charters of development banks were amended to establish that the objective of DFIs is to promote the development of the productive sectors, while maintaining their capital, and offered them greater autonomy of operation in exchange for improved governance and accountability. Three changes were incorporated to strengthen governance. First, the independence of their Boards was

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enhanced through the mandatory participation of two independent and qualified members.74 The Treasury Secretary is always the chairman of the board, and two-thirds of the boards are represented by various departments of the federal government. Second, disclosure and transparency was strengthened with the annual submission of operational and financial plans to the Government and Congress. Third, a risk management committee was created at each institution through a regulation issued by the CNBV. Although exceptions apply, there has been a general tendency to change the pricing of products to better reflect costs. Guarantees of market products with higher risks and a social or market failure rationale are supported by counter-guarantee funds directly financed from the Federal Government in order to make subsidies more transparent and allay the tension between the need to maintain a sound financial performance and fulfill specific policy objectives.

21. Broadly speaking, governance changes and other institutional reforms have contributed to improvements in the overall financial performance of DFIs. Development banks have maintained capital levels above the regulatory minimum, which is the same as that of commercial banks. The net capital to risk weighted assets indicator presents a large spread among institutions, with the lowest at 12.5 percent for SHF and the highest at 27 for Bansefi. Return on assets has varied over time and among the development banks, with the highest variation experienced by Banobras and Bancomext, both showing positive positions in 2008. Margins of intermediation tend to be thin reflecting the tension between profitability and their public policy mandate.

22. Delinquency rates have been on a downward trend until 2008, and there is a good coverage ratio of non-performing loans. The ratio of NPLs to total loans had been dropping for all development banks and in particular for Bancomext that saw a decrease from about 11% in December 2006 to 1.7% in 2008, as reported by the CNBV. However, March 2009 reported figures suggest a slight increase in NPLs for Bancomext and SHF close to 2%. All others remained below 0.5%. In terms of loan loss reserves to NPLs, these range from 254 percent for Banjercito to 1,228 for Nafin in March 2009. SHF saw a big decrease from 1,556 percent in December 2008 to 519 in March 2009, while Bancomext also experienced a small, but not significant, decrease.

Policy Responses to the Global Financial Crisis

23. In the wake of the global financial crisis, the Government has sustained the overall policy direction laid in the National Development Plan of fostering access to finance with stability but has moved quickly to mitigate risks exposed by the global crisis through regulatory changes and a more active role played by DFIs to prevent a sharp credit contraction by private financial institutions.

74 Shareholding is divided in two types of shares: A shares (66% of total) can only be held by the Government and B shares can be held by the public but in practice are held by the Government. The former are always represented by public officials, while the latter might be represented by non-government officials but appointed by the Federal Government.

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Legal and Regulatory Reforms

24. The most important regulatory reforms implemented in 2009 address (i) the protection of consumers of financial services, (ii) provision of banking services through third agents, and (iii) market transparency. Some prudential regulations were also enhanced. The global financial crisis brought to the fore the importance of fostering access to finance together with adequate consumer information. The enactment of the Law on Transparency and Ordering of Financial Services in 2007 constituted a positive step. The Law entrusted the CNBV with the issuance of criteria on acceptable practices by regulated credit institutions for consumer information and marketing, and its supervision and enforcement; and similar provisions to CONDUSEF in regard to non-regulated SOFOMEs. Accordingly, the CNBV issued regulations on consumer information and started to develop the capacity to supervise them, but its main focus remained on financial stability. The global financial crisis exposed the difficulties and greater urgency of addressing issues related to the protection of consumers of financial services and decided to entrust this responsibility to a specialized agency CONDUSEF75.

25. In this spirit, the Law Protecting and Defending Users of Financial Services was amended in June 2009. CONDUSEF will be responsible for (i) educating users of financial services, (ii) promoting an equal and fair relationship between financial institutions and its users, (iii) informing the public on services provided by financial institutions (including costs and quality of services, and level of claims raised by consumers against financial institutions), (iv) facilitating arbitration services between financial institutions and users, (v) requiring financing institutions to take adequate measures to prevent or address business practices that impair consumers´ rights; and (vi) regulating marketing practices and financial contracts of credit institutions in order to ensure that consumers are aware of their rights and responsibilities. The institution was already responsible for items (i) to (iv) above prior to 2008, but the lack of capacity to penalize institutions severely constrained its effectiveness. The legal reform addresses these gaps by expanding CONDUSEF´s capacities to regulate, supervise (including capacity to visit premises), and issue penalties. The institution will face the challenge of balancing the two attributions of arbitrage and regulation. The CNBV will no longer be responsible for regulating marketing and contracts of credit institutions with regard to consumer protection. The Federal Government will issue a secondary regulation defining in greater detail the scope of supervisory responsibilities and capacities of CONDUSEF. The law envisages a transition period of 180 days for the new [regulatory] authorities to become effective. The institution is currently developing an institutional strengthening plan to meet the new challenges.

26. The Law on Credit Institutions was amended in June 2009 to facilitate the development of new, secure and cost-effective channels to extend financial services to underserved market segments. The legal reforms will allow banking institutions to

75 CONDUSEF´s Board is comprised of a representative from SHCP, a representative from Bank of Mexico, a representative from each of the financial supervisory agencies, and three representatives from the National Consultative Council. CONDUSEF´s president will participate with voice but no vote.

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contract third parties (e.g., retail chains and retail stores) in order to provide services (deposit taking, payments, transfers, and receipt of documentation to open a bank account or request a credit) on behalf of the bank. These new channels could greatly expand the “outreach of banking institutions” which is currently limited, especially in the Southern part of the country (see Figures 5 and 6.) The bank will retain at all times the responsibility over the transactions conducted vis-à-vis the customer, while the agent will only provide a transactional channel. This provision is critical to provide certainty to transactions and minimize the risks to the population using these services. Tight requirements have been imposed on banking institutions that provide services through agents and banking institutions that contract them will be liable and penalized for the non-compliance of the former. An agent will be able to provide services to more than one bank in order to encourage a more competitive market. The CNBV has already issued regulations detailing operational requirements for agent banking and allowing correspondent banking through networks. At least nine banking institutions have already submitted a request to CNBV to provide these services. Complementing the above, the [Anti-money Laundering Law was amended in May 2009] provides a simplified regime for the opening and operation of low value bank accounts. The CNBV plans to issue soon a new regulation allowing the use of mobile phones for transaction payments of low value.

Figure 5. Number of Bank Branches per 1,000 inhabitants

Figure 6. Mexico. Number of Bank Branches per Million Inhabitants per State

Source: CNBV presentation (2009) Note: CNBV presentation (2009)

27. The Capital Markets Law (Article 104) was amended in May 2009 to address the lack of transparency concerning derivative instruments used by market issuers. As noted earlier, speculative derivative positions by several large Mexican corporations generated commercial paper defaults in October 2008 that severely heightened risk aversion and nearly brought to a halt the commercial paper market. To address this serious gap, restore market confidence, and prevent similar situations in the future, the reform to the Capital Markets Law requires market issuers to inform on their derivative positions, including payment conditions and the possible contingencies that such positions imply on the issuer’s financial position. The CNBV also issued a regulation establishing new reserve requirements for consumer lending provisions which require estimates on expected losses to be determined on a forward looking-basis. Banking institutions will have the choice to

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absorb the new requirements as a one-time charge or spread it on a monthly basis over a one-year period.

28. The transparency and accountability of development banks and trust funds was improved through amendments to the Law of Credit Institutions in May 2009. Strengthening the accountability framework was important given the increased role played by development banks in the context of the global crisis and heightened risk aversion by the private sector as discussed below. The three main changes: (i) development trust funds will have to submit annual operational and financial plans to Congress through the Government (as development banks) currently do; (ii) development banks and development trust funds will have to publish indicators measuring their services to their target populations according to guidelines to be issued by the SHCP; and (iii) the SHCP will have to conduct and publish two independent evaluations on development banks or development trust funds that will include inter alia an assessment of how these institutions are meeting the access to finance objectives defined in their organic laws and their coordination activities with other public institutions to promote a more efficient use of public resources. The first two independent evaluations concerning the operations of Bansefi and SHF will be presented to Congress in April 2010. The CNBV also issued a regulation that can allow, on a case by case basis, temporary increases in the credit concentration ratio of DFIs. While this could increase the risk exposure of DFIs, the risk is partially mitigated by the fact this is a temporary measure with a sunset clause and that the performance of these institutions will be supervised by the CNBV.

New Counter-cyclical Measures Implemented through Development Finance Institutions

29. In parallel to the above regulatory measures, DFIs have expanded financing activities to prevent a sharp credit crunch in light of deleveraging and increased risk aversion by private financial agents. From September 2008 through June 2009, the credit portfolio supported (directly or indirectly) by development banks76 had increased by 38% in real terms--equivalent to an annual growth rate of 53% (Figure 7). By June 2009, the (direct and indirect) credit portfolio of development banks was equivalent to 47% of commercial bank credit extended to the business sector, housing and infrastructure compared to 36% in September 2008.

76 Indirect support includes loan and commercial paper guarantees.

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Figure 7. Financing Supported by Development Finance Institutions (million pesos)

Source: SHCP Presentation

30. Nafin and Bancomext launched an emergency program guaranteeing up to 50% of commercial paper issued by corporations meeting minimum credit rating benchmarks. This program was critical in preventing the “drying up” of the commercial paper market, which is actively used by Mexico’s corporate sector. The program was retrenched in July 2009 as activity in this market picked up again. Bancomext provided direct lending to large corporations experiencing refinancing difficulties in capital markets and overcollateralized credits to protect the quality of its portfolio. In addition, NAFIN and Bancomext expanded their support to SME finance through both guarantees and credit lines provided to qualified financial intermediaries. Producers in the rural sector also benefitted from expanded financing by FIRA and Financiera Rural. December 2008 compared to December 2006.

31. In the infrastructure sector, Banobras increased financing to support the development of new infrastructure projects and prevent the disruption of existing ones due to sponsors’ lack of access to private financing. In the housing sector, SHF stepped in to facilitate the flow of credit to mortgage originating institutions (Sofoles and Sofomes) and prevent a collapse of the nascent residential mortgage-backed security market. The institution has also continued to maintain an emphasis on credit provision to households earning less than 6 minimum wages.

Medium-term Policy trends

32. The Government intends to continue promoting the access to finance with stability agenda in the medium term. To this end, a number of proposals are already underway. The Government is drafting proposals to establish a more agile and suitable framework for bank liquidation. The current legal framework requires a judicial bankruptcy procedure which is slow and cumbersome.

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33. It is also collaborating with Congress on a proposal to establish a stronger regulatory framework for specialized financial institutions (known by the acronyms of Sofoles and Sofomes). These reforms are in response to recent defaults on unsecured debt by two larger Sofoles noted above. While these institutions do not currently present a systematic risk, the authorities would like to prevent regulatory arbitrage and establish a more adequate regulatory framework under which they can expand. Currently, only Sofomes related to banks and financial groups are regulated by the CNBV. The proposal expands the regulatory and supervisory framework to Sofomes that finance their operations through capital markets and those related by ownership to savings institutions.77 It establishes a broad prudential framework entrusting the CNBV with the issuance of more detailed regulations. 78 In regard to ownership links, however, the proposal sets a more precise definition to avoid regulatory arbitrage. In addition, it defines a process for the authorization and cancellation of a Sofome license and sanctions that would apply in case of non-compliance with the regulatory framework. The safety net framework that would apply to these institutions may need further clarification. Sofomes would be allowed a transition period to adapt to the new framework. Sofoles could apply for a license to become a regulated Sofome.

34. The Government has also presented to Congress a draft proposal to foster a more competitive retail payment system. Further prudential changes on capital adequacy, leveraging and other critical issues area also expected over the coming years in the context of the G-20 Framework Agreement. In addition, the Government is planning to develop a system and a set of indicators to measure access to finance on a regular basis and monitor the impact of its policies.

35. The financial sector agenda envisages the continued institutional strengthening of DFIs and the merger of NAFIN, Bancomext and the Mining Trust Fund to profit from synergies. The first steps in this direction were already undertaken in 2007 by appointing the same Director General to both institutions. The two institutions also share a number of other key senior management appointments (e.g., Treasurer).

77 Other Sofomes may apply for the license of regulated Sofome or remain unregulated. 78 Those linked to savings institutions would have to comply with the regulatory provisions applying to savings institutions.

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Annex 5c. Labor Policies

Recent evolution of labor market indicators

1. Historically, the Mexican labor market has been characterized by a low level of unemployment, yet high persistent rates of informality. Values of informal employment vary by source and definition. Figure 1 depicts informal employment defined in terms of lack of social security coverage from two distinct sources.79 Informal employment has persistently represented over half of total employment since the beginning of the 90s.

Figure 1: Mexico: GDP Growth, Unemployment and Informal Employment rates

Source: Authors’ elaboration using INEGI, Banco de Información Económica, ENEU and ENOE surveys, and estimates of informal employment by Levy ( 2008). Notes: 1. Informal employment is defined as lack of social security coverage (i.e., workers under this definition are those who are not affiliated to or covered by any social security institute such as IMSS, ISSTE, etc). 2. The arrows indicate the corresponding source for each informality series. Unemployment rates correspond to urban unemployment until 2000 (from ENEU) and to national unemployment henceforth (from ENOE).

79 The two sources are: (i) direct administrative records of social security institutions as used by Levy (2008), and (ii) self-reported access to social security from ENOE surveys.

50

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Levy, 2008

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2. In the past two decades, unemployment has peaked during economic contractions (reaching its highest rate of 7.4 percent during the 1995 Tequila Crisis) while informality has shown upward and downward trends during periods of growth in the economy (Figure 1). The international crisis has produced a deep contraction of Mexico’s GDP and a consequent increase in both unemployment and informality. Zooming-in on recent monthly data (from 2006 to the present) reveals a synchronized deterioration of labor market indicators, namely a decline in participation and a rise in unemployment commencing in the last quarter of 2008 (Figures 2 and 3). Between September 2008 and June 2009, the number of workers affiliated to the Social Security System (IMSS) declined by nearly 700,000. The unemployment rate reached 6.28 percent in August 2009, the highest figure since February 1996 in the aftermath of the Tequila crisis.

Figure 2: Recent Participation Rates

Source: Authors’ elaboration based on ENOE surveys 2006-2009.

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Figure 3: Recent Unemployment Rates

Source: Authors’ elaboration based on ENOE surveys (2006-2009).

3. The recent deterioration of labor market performance is further illustrated by the destruction in net jobs, which amounted to half a million jobs between June 2008 and June 2009. In the case of non-salaried labor, the largest net destruction occurred at the time of the outbreak of the crisis: over 1,200,000 net jobs were lost in the fourth quarter of 2008 (Figure 4). This loss surpassed the diminishing net job creation of salaried jobs (around half a million), which led to a large net job destruction of more than seven hundred thousand jobs by the end of 2008. The first quarter of 2009 showed a further net destruction of non-salaried jobs, which again surpassed the almost flat net growth of salaried jobs (around 50 thousand). In the second quarter of 2009, with the additional shock of the AH1N1-flu outbreak, there is a net job destruction of salaried jobs for the first time, which was compounded by the continued (although smaller) destruction in non-salaried jobs.

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Figure 4: Net Job Creation/Destruction

Source: Authors’ elaboration based on ENOE surveys 2006-1009.

4. Linked to the slow growth of formal employment, two other prominent features of the Mexican labor market have been slow growth in labor productivity and in real wages. Total labor productivity, in terms of GDP per worker, declined throughout the 1980’s and remained stagnant until the middle of the nineties, presenting a sharp drop in 1995 due to the crisis. Average labor productivity has subsequently grown in most economic sectors (Figure 5).

5. The agriculture and manufacturing sectors are mainly accountable for the recent improvement in productivity. Yet, the sustained improvement in these two sectors due to technological gains has been cancelled out to some extent by the poor performance in the services sector, which concentrates a significant proportion of the Mexican informal work force (Figure 5). Low productivity in sectors with large shares of informal labor is due to the low investment in technology adoption and worker training in these sectors (Levy, 2008). To make matters worse, the service sector has been largely responsible for job creation in Mexico since the early nineties (3 out of every 4 new jobs were created in the service sector) causing a notable negative impact on overall average labor productivity (Pagés and Scarpetta, 2007).

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Figure 5: Labor Productivity Index

Source: ILO, "Key Indicators of the Labor Market" (2005), 5th edition.

Figure 6: Real Wages Index

Source: Staff calculations based on registered payments to IMSS; STPS 'Estadísticas del sector’.

PRODUCTIVIDAD LABORAL(segun OIT, KILM 5a edicion)

40

60

80

100

120

140

160

19

80

19

81

19

82

19

83

19

84

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86

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96

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Total manufactura transporte y comunicaciones comercio agricultura

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1994 1996 1998 2000 2001 2002 2003 2004 2005 2006 2007 2008

Rea

l pes

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) pe

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y

Total Primary Extractive industries Transformation industriesConstruction Electricity and water Commerce Transport/communicationsFinancial Services/Rent Sociales services

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6. The trends in real wages also show modest growth rates in recent years. Despite improvement in a few sectors (e.g., financial services and extractive industries) real wages have recovered at a sluggish pace following the crisis of the mid-nineties (Figure 6). More recent monthly wage data indicates that the service sector has endured a severe decline in real wages since early 2008, whereas wages in the manufacturing sector, which maintained their real value for most of 2008, have started to record declines in 2009 (Figure 7)

Figure 7. Seasonally Adjusted Real Wage Index for Workers in Selected Activities

Source: INEGI, Banco de Información Económica

7. In summary, the international crisis has produced a severe shock to the Mexican labor market through an important rise in unemployment rates and a decline in the labor participation rate. For the year ending in June 2009, Mexico has lost more than half a million jobs, and the number of unemployed has risen by more than seven hundred thousand. The sharp deterioration of the labor market follows a period of sluggish wage growth in most sectors and has led to an important recent fall in real wages in some sectors.

Labor policies to confront the international crisis in Mexico

8. The most important policy reaction to the global crisis by the Mexican Government is the National Agreement in Favor of the Family Economy and Employment (ANFEFE--Acuerdo Nacional a Favor de la Economía Familiar y el Empleo). This agreement was prepared during the last quarter of 2008 by the Office of President Calderón. Concerned about the depth of the global crisis, the Office of the

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President initiated a series of consultations with the most important sectors of the Mexican economy and society, so that a concerted response to the adverse economic environment could be convened.

9. On January 7, 2009, President Calderón announced to the Nation the content of the agreement. It contained a series of policy actions to be adopted by the Federal Government during fiscal year 2009, as well as a string of commitments on the part of several public and private Mexican institutions (inter alia the Federal Government, the Congress of the Union, heads of the Executive of Federal States, and labor and business organizations). The agreement was signed by a large set of high-ranking officials of these institutions.

10. Policy actions by the Federal Government included in the agreement are grouped into five pillars. The first pillar, Employment and Workers´ Support (Apoyo al Empleo y a los Trabajadores) includes specific actions to create employment and provide support to the unemployed. The second, Support to Mexican Families (Apoyo a las Familias Mexicanas) introduces price subsidies and income support to protect household consumption and sustain households’ disposable income. Third, Support to Industry and SMEs (Apoyo a la Industria y a las Pequeñas y Medianas Empresas) provides facilities for new capital investment. Fourth, Infrastructure Investment for Competitiveness and Employment (Inversión en Infraestructura para la Competitividad y el Empleo) is the main fiscal impulse investment program of the agreement. And, fifth, Transparent, Efficient and Timely Public Expenditures (Gasto Público Transparente, Eficiente y Oportuno) includes a set of administrative measures to promote more efficient and expedite government expenditures.

11. Although pillars three and four are expected to have an indirect impact on employment creation, the first pillar focuses on labor policy measures. This pillar has the explicit objective of “…adopting specific actions to promote more employment both in the public and private sector … as well as concrete measures to provide support to those who lose their job…”80 This pillar contains five components (Table 1). In addition to the ANFEFE, the Government has prepared a proposal to reform the Labor Labor and address structural issues affecting the labor market.

80 Acuerdo Nacional para la Economía Familiar y el Empleo, pp. 4 and 5

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Table 1. Components of the ANFEFE’s Employment Pillar Component Objective Budget allocation (Mexican

pesos) 1. Expansion of the Temporary Employment Program (PET)

To provide temporary employment to the unemployed and underemployed in urban and rural areas

2,200 million which represent a 40% increase with respect to the 2008 budget allocation.

2. Launch of the Employment Preservation Program (PPE)

To preserve the demand for labor and avoid the dismissal of workers by the firms most vulnerable to the global economic environment (specially the exports sector)

2,000 million

3. Increased access to retirement accounts by the unemployed (Sistema de Ahorro para el Retiro en caso de Desempleo)

To provide a temporary income source for the unemployed

No additional fiscal budget allocation for this policy.

4. Increased Social Security coverage for the unemployed

To extend Social Security coverage of the unemployed from two months to six months.

2,600 million

5. Enhancement of the National Employment Service

To improve the conditions of the workforce by providing better labor services (inter alia training courses, information and networking services, and support to the self-employed)

1,500 million

Source: Authors’ elaboration based on the “Acuerdo Nacional en Favor de la Economía Familiar y el Empleo”.

12. The Employment support pillar of the ANFEFE agreement is a combination of both active and passive labor market policies, which are further discussed below. The Mexican Government has taken advantage of the recent modernization and improved effectiveness of existing programs to elicit a rapid response to the crisis. Some components have a temporary nature (extension of health and maternity benefits to the unemployed and wage subsidies paid by the Federal Government to employees exposed to temporary suspension of work or “paros técnicos”), whereas others have a more permanent character (the expansion of the Temporary Employment Program and the National Employment Service as well as withdrawals from retirement savings accounts).

13. The reorganization and expansion of active and passive labor market policies is an important step to strengthen institutional mechanisms for dealing with cyclical or structural shocks. Despite having most of the standard labor market policy instruments, Mexico´s expenditure in these tools has been very low by comparison to other OECD countries (OECD, 2009).

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Active labor market policies in Mexico

14. Active labor market policies (ALMPs) directly promote the creation of jobs among the unemployed and underemployed. In Mexico, the National Employment Service (SNE) constitutes the overarching umbrella for implementing ALMPs, including programs for information and networking, training and temporary public employment. ALMPs under the Employment pillar of the ANFEFE have concentrated on the expansion of the SNE resources and its services.

Figure 8: Summary Statistics of SNE Programs

(January-August 2009)

Source: Authors' calculations based on STPS official statistics 1/ People serviced refers to the number of service events; and placements refer to number of placement events. 2/ People serviced refers to the number of service events; and placements refer to number of placements, workers employed temporarily and whose jobs are preserved. 3/ People serviced refers to the number of people serviced; and placements to number of preserved jobs. 4/ People serviced refers to the number of people serviced; and placements refers to number of preserved jobs. In this case, the PET only includes urban beneficiaries. See Figure 9 to examine the entire coverage of PET beneficiaries (urban and rural).

15. The National Employment Service: The National Employment Service (SNE) constitutes an overarching umbrella of labor services offered by the Ministry of Labor and Social Provision. Since it was first launched in 1978, the national system of labor services has undergone several changes to its complex structure. It currently encompasses 5 separate strategies: (i) a host of job networking services (Servicios de Vinculación Laboral - SVL); (ii) the Employment Support Program (Programa de Apoyo al Empleo- PAE); (iii) the Employment Fostering Program (Programa de Fomento al Empleo - PFE); (iv) the Support Program for emerging workers in the Services Sector (Programa de Apoyo Emergente a los Trabajadores del Sector Servicios – PAETTSS); and (v) the Temporary Employment Program (Programa de Empleo Temporal- PET), which is

People serviced

Placements and/or jobs preserved

2,311,666

353,740

301,685 157,794

6,415 6,415 52,024 52,024 24,568 13,763 -

500,000

1,000,000

1,500,000

2,000,000

2,500,000

. . . . . . . . . .

SVL / 1 PAE / 2 PFE / 3 PAETSS / 3 PET / 4

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further discussed below. Figure 8 shows the distribution of individuals serviced and placements for 2009 among the 5 programs which conform the SNE.

16. The SNE has expanded its budget by 34 percent between January to August 2009 compared to the same period a year earlier, and its coverage (in terms of individuals serviced81) by 19 percent during the same period (Table 2). By August 2009, the program had already executed 80 percent of the budget committed in the ANFEFE for 2009

Table 2. Budget and Coverage Results for SNE (2008-2009)1 2008 2009 Difference (2009

versus 2008) Budget (in million pesos)

Budget executed

897.7 1,202.5 33.9% increase

Coverage Individuals serviced

2,257,458 2,696,358 19.4% increase

Source: Authors’ elaboration based on Secretaría de Trabajo y Previsión Social (2009) 1 All values correspond to the period from January to August of the year specified

17. The Temporary Employment Program: The Temporary Employment Program (PET) was originally launched in 1995 in response to the economic crisis of the times and operated in the rural area exclusively. Initially, the program was jointly managed by the Ministry of Communications and Transport (SCT) and the Ministry of Social Development (SEDESOL). Subsequently, the Ministry of Environment and Natural Resources (SEMARNAT) and the Ministry of Agriculture and Rural Development (SAGARPA) also joined in program management. From 2001 on, the participation of the SAGARPA was gradually diminished and phased out in 2009, when the STPS was granted responsibility for its coordination to better integrate it with other labor market policies. The PET is currently administered and financed jointly by three ministries: Social Development (SEDESOL); SEMARNAT; and Transport and Communications (SCT). Broadly speaking, the reorganization of the PET around the coordination of the STPS will help focus the program on its job creation goal and direct resources to those areas where unemployment rates are higher. This will make the program a more complete mechanism of income compensation helping not only areas with problems of poverty or temporary, adverse weather conditions, but also localities with unemployment shocks.

18. Along with the institutional changes, several other modifications were introduced in an effort to enhance the program’s effectiveness and targeting. The most important changes are (i) the PET’s extension to the urban areas, targeting those with the highest rates of unemployment; (ii) the participation of the SNE as an important channel to

81 However, the coverage measured in terms in of the actual placements or jobs preserved has remained nearly unchanged (in fact it fell by 0.4% between 2008 and 2009).

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facilitate access and reach out to potential beneficiaries; (iii) the harmonization of information under one coordinated strategy; (iv) the increased frequency of results’ publications and coordination committee gatherings; and (v) the program’s systematic evaluation82.

Table 3. Budget Results for PET (January through September 13, 2009)

Ministry Budgetary allocation (million pesos)

Amount spent (million pesos)

Percent of budget allocation

implemented

SEDESOL 743 532.7 72 % SCT 1,144 994.65 87 % SEMARNAT 313 290.53 93 % TOTAL 2,200 1,817.88 83 %

Source: Authors’ elaboration based on Secretaría del Trabajo y Previsión Social (2009) “Acciones y Mejoras del PET 2009”; official presentation by the STPS.* All figures correspond to the period between January 1st and September 13, 2009

Table 4. Budget Execution for PET: Evolution between 2008 and 2009*

(in million pesos) 2008 2009 Percent increase

(2009 over 2008) SEDESOL 411.5 871.8 112% SCT 68.2 268.1 293% SEMARNAT 133.7 437 227% TOTAL 613.4 1,576.9 157%

Source: Authors’ elaboration based on Secretaría de Hacienda y Crédito Público, “Informes sobre la situación económica, las finanzas públicas y la deuda pública” (Segundo Trimestre de 2008 y 2009) * All figures correspond to the period between January and June of the year specified.

19. Following administrative reforms and further efforts to improve targeting, the Government increased the budgetary allocation for 2009. Figure 9 along with Table 3 and Table 4 present the PET’s coverage and expenditure figures for 2009 disaggregated by ministries. Currently, the SCT is responsible for more than half of the program’s budget and beneficiaries (55 and 56 percent correspondingly). The figures show the PET has indeed expanded its budget execution by 157 percent during the period January-June 2009 compared to the same period in 2008, and 83 percent of the 2009 budget allocation had been executed by September 2009.

82 See “Interventions and Improvements on the PET”, presentation by the STPS, August 2009.

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Figure 9. Summary Statistics of PET Coverage (2009*)

*At September 13, 2009 Source: Secretaría de Trabajo y Previsión Social (2009) “Acciones y Mejoras del PET 2009”; official presentation by the STPS.

Passive labor market policies

20. Passive labor market policies aim at sustaining the standard of living of individuals, when they are not employed. The Employment pillar of the ANFEFE comprises to passive labor market measures: i) expanded withdrawals from pension savings accounts for unemployed workers and ii) extended coverage of health and maternity benefits for unemployed workers who contributed to the system. The latter is a temporary measure that protects workers and their families during what can be expected to have been the worst period of the crisis (first and second quarters of 2009). The former is a permanent change with more substantive implications.

21. Withdrawals from mandatory retirement savings accounts for the unemployed: Mexico does not have a conventional unemployment insurance mechanism that constitutes the bulk of passive labor policies in OECD countries. However, the reform of the Social Security System that created individual pension accounts had a provision for withdrawing a limited amount of resources in the event of unemployment. In this regard, Mexico has a quasi-form of what is called Unemployment Insurance Savings Accounts (UISAs).83 UISAs are an unemployment protection mechanism that is not based on pooling risks through collection of contributions from employers and employees with different propensities to unemployment. Instead, it is an individual savings account (with or without public funding) from which individuals can withdraw resources when out of work. This type of mechanisms has also been adopted in other countries (e.g. Chile, Brazil, and Sri Lanka among others). The Mexican provision, however, does not consist

83 See Vodopivec (2008)

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of a separate savings account but allows contributors to make limited use of savings from their pension account.

22. The recent reform of the Social Security Law facilitated and expanded the use of individual retirement accounts by introducing two fundamental changes. First, the maximum withdrawal was raised to the lowest between 90 days of salary or 11.5 percent of the accumulated savings compared to the lowest between 75 days or 10 percent of the savings stock prior to the reform. This provision applies to workers with more than five years of contributions (not necessarily continuous). Second, the number of contributions necessary for being eligible was reduced from five to three years (non-consecutive in both cases). Workers with more than three years but less than five years are allowed to withdraw up to 30 days of salary. The requisite number of days unemployed remains at 46 as certified by the IMSS, and the facility cannot be used again for another five years.

23. Preliminary information about the use of the facility shows that the take up rate by unemployed workers has increased dramatically (Table 5). As the Mexican economy worsened during 2008, the number of workers withdrawing from the accounts rose surpassing 56,000 in December 2008 compared to about 36,000 in January 2008. Following the reform in May 2009, the number of account holders grew by nearly 40 percent in only one month.

Table 5. Use of Unemployment Withdrawals from Individual Pension Accounts

Number of Individual Accounts

Average withdrawal Total

(thousands) (pesos) (million pesos)

2008 January 36 4,284 153 2008 December 56 3,906 220 2009 May 86 4,100 351 2009 June 121 5,932 716 2009 August 134 5,833 783 2008 (whole year) 607 3,856 2,342 2009 (up to August) 797 4,849 3,866

Source: Authors’ elaboration based on CONSAR

24. The reform allowed the Government to instrument a rapid response to an increasing problem of unemployment due to the international crisis. However, the limited nature of the compensation in terms of coverage (nearly eight hundred thousand of beneficiaries for a total number of unemployed around 2.3 million, by August 2009), duration of the benefit (only once every five years) and replacement rate (up to 50 percent of basic wage for up to six months) calls for a reconsideration of the

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unemployment protection mechanisms in Mexico. Most concerning, the current scheme poses a high threat of eroding workers’ pension funds in the long run. This risk is specially born by those workers most vulnerable to suffer long periods of unemployment. In this context, the current reform is an indication of the need for more flexible and dynamic forms of income protection, beyond the current unemployment withdrawals provision in the Social Security Law and the conventional severance payments in the Federal Labor Law.

Proposal to reform the Federal Labor Law

25. On February 9th, 2009, the Mexican Labor Secretary, Javier Lozano, presented a proposal to reform the Mexican Federal Labor Law (LFT). This proposal currently constitutes the seventh point in President Calderon’s Decálogo para Cambiar de Fondo a México presented in the Government’s Third Official Report (‘Tercer Informe de Gobierno’) in September 2008. The proposed reform to the labor bill is not presented as an exclusive initiative of the current Administration, but rather as a synthesis of over 250 different initiatives presented to Congress during the last eleven years. It is an effort to find common ground between employers and employees and the result of the STPS’s consultation efforts with diverse stakeholders (i.e., employers and unions). The proposal was officially presented at the forum “Mexico ante la Crisis: ¿Qué hacer para Crecer” organized by the Senate and the Chamber of Representatives (H. Congreso de la Unión) in February 2009.

26. The reform bill addresses inter alia three important issues. First, it proposes the introduction of new types of contracts, which can potentially expand the size of formal employment among some groups of workers. Second, the proposal includes several provisions to expedite the resolution of labor conflicts of the Juntas de Conciliacion y Arbitraje (JCA), which may alter significantly the costs of labor disputes. Third, the reform bill attempts to address the issue of enhancing productivity growth through mandatory employer-provided training and through Productivity Councils (Comisiones Mixtas de Productividad, Capacitacion y Adiestramiento). Additionally, there are a series of new stipulations regarding the work of women, children and disabled workers as well as migrants and indigenous population.

27. A World Bank analysis of the reform proposal84 indicates that the proposal contains elements that constitute an initial positive step. Further significant changes to labor regulations will be needed to eliminate persisting distortions and inefficiencies present in the Mexican labor market. Notwithstanding this, the LFT was originally published in April 1970, and few substantial changes have been introduced for nearly 40 years. In this context, the reform proposal is a credit-worthy effort that could potentially set the stage for a reform process to address the core issues affecting the labor market in several stages.

84 World Bank (2009), “Labor reform in Mexico: Analysis of the Mexican Ministry of Labor’s Proposal”, August 2009.

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Conclusion

28. The Government of Mexico has adopted a series of measures that indicate an important effort to both deal with the cyclical impact of the international crisis and lay the ground for stronger labor market policy instruments to face future cyclical and structural shocks. It has also shown clear intentions to continue strengthening its labor market institutions and has expressed its commitment to submit a proposal to reform the Federal Labor Law in the near future. Even though the scope of the current proposal may be limited, its direction is correct. The eventual approval by Congress of a reform to the Labor Law could prove the first step in a series of reforms to modernize labor legislation in Mexico.

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References

Levy, Santiago (2008) Good Intentions, Bad Outcomes, Brookings Institution Press, Washington, D.C. OECD (2009), Employment Outlook 2009. “Tackling the Jobs crisis” Paris: OECD. Presidencia de la República de México (2009), “Acuerdo Nacional a favor de la Economía Familiar y el Empleo”. Enero de 2009. SEDESOL (2009), “Acuerdo por el que los integrantes del Comité Técnico del Programa de Empleo Temporal, modifican las Reglas de Operación del Programa de Empleo Temporal para el Ejercicio Fiscal 2009.” Diario Oficial (Séptima Sesión, Diciembre 29, 2008), STPS (2009) “Acciones y Mejoras del PET 2009”; official presentation by the STPS. Vodopivec. Milan(2004) Income Support for the Unemployed: Issues and Options. The World Bank. Washington D.C. World Bank (2009), “Labor reform in Mexico: Analysis of the Mexican Ministry of Labor’s Proposal”, August 2009.

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Annex 5d. Trade Policy

MEXICO’S TRADE POLICY ENVIRONMENT Policy environment

1. The financial crisis severely impacted Mexico's foreign trade. Although during 2008 exports increased by 7.6 percent due to the increase in oil prices during the first semester, Mexico's global exports and imports fell around 30 percent during the first half of 2009. Oil exports decreased by more than 53 percent while non-oil exports decreased by 26 percent in the second quarter of 200985. In the first quarter a fall of 58 percent and 21.8 percent was observed for both categories, respectively.

2. The performance of Mexico's foreign trade is closely linked to exports to the United States (Figure 1). The United States economy represents the destination of 80 percent of total Mexican merchandise exports. While exports to the U.S. fell 29 percent in this period, exports to Latin America and the European Union led the decline in Mexican exports (Table 1). Because of its close economic links to the U.S. economy, the recovery of Mexican’s exports depends on the evolution of the crisis in the United States.

3. Mexican’s exports to the U.S. are relatively concentrated in a few products categories. Five categories of the Harmonized Tariff System (HTS) represent 74 percent of Mexico exports to the United States. These categories are: (i) electrical machinery and equipment and parts thereof; sound recorders and reproducers, television recorders and reproducers, parts and accessories (24.7 percent); (ii) mineral fuels, mineral oils and products of their distillation; bituminous substances; mineral waxes (19.7 percent); (iii) vehicles, other than railway or tramway rolling stock, and parts and accessories thereof (14.9 percent); (iv) nuclear reactors, boilers, machinery and mechanical appliances; parts thereof (11.4 percent); and (v) optical, photographic, cinematographic, measuring, checking, precision, medical or surgical instruments and apparatus; parts and accessories thereof (3.5 percent). Among U.S. imports, the most affected categories were oil and vehicles that faced a contraction of 50 percent and 43.5 percent, respectively (Table 2).

85 Banco de Mexico, Informe sobre la Inflacion Enero-Marzo and Abril-Junio, 2009.

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Mexico's total exportsMexico´s Exports to the U.S.

Figure 1: Mexico´s Exports (Jan-Jun each year)

Source: Ministry of Economy

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Table 1: Mexico Trade by Region. (US$ billions)

EXPORTS IMPORTS

Annual JANUARY-JUNE Annual JANUARY-JUNE

2007 2008 2007 2008 2009 2007 2008 2007 2008 2009

TOTAL 272.04 292.64 127.93 149.49 104.31 283.23 310.13 132.93 153.32 105.52

North America

229.90 241.69 108.88 122.91 88.15 148.55 162.07 70.78 82.54 53.89

United States 223.40 234.56 105.87 119.70 84.57 140.57 152.62 67.06 77.84 50.66

Canada 6.49 7.13 3.01 3.21 3.58 7.98 9.45 3.72 4.69 3.23 LAIA 11.09 14.15 5.02 6.72 4.34 12.48 12.12 5.95 5.81 3.87 Central America

3.57 4.03 1.55 2.11 1.40 1.54 1.73 0.70 0.86 0.63

European Union

13.94 17.08 6.37 9.22 5.11 33.84 39.16 16.16 18.74 12.50

EFTA 0.26 0.64 0.09 0.36 0.23 1.51 1.69 0.69 0.80 0.63

NIC´S* 1.62 1.67 0.75 0.88 0.57 21.21 22.51 9.24 10.92 7.85

Japan 1.92 2.07 0.87 1.05 0.73 16.36 16.33 7.78 7.78 5.13

China 1.90 2.05 0.85 1.07 1.07 29.79 34.75 13.16 16.47 14.21

Source: Author’s calculations based on information from the Ministry of Economy.

NIC´s: Newly industrialized countries.

Table 2: Major U.S. Imports from Mexico

HTS Category 2007 2008 2008 2009 Change

Jan-Jul 2009/2008

million dollars Percent of total

Jan.-Jul million dollars

All categories 210,158.8 216,328.4 100.0 129,310.5 93,887.6 -27.4 85.--electrical machinery and equipment and parts thereof; sound recorders and reproducers, television recorders and reproducers, parts and accessories

54,827.0 53,366.5 24.7 31,431.3 24,640.0 -21.6

27.--mineral fuels, mineral oils and products of their distillation; bituminous substances; mineral waxes 33,529.8 42,645.6 19.7 26,055.4 12,971.2 -50.2

87.--vehicles, other than railway or tramway rolling stock, and parts and accessories thereof 33,901.7 32,140.0 14.9 18,702.0 11,998.7 -35.8

Motor cars and other motor vehicles designed to transport people 13,497.8 13,954.8 6.5 7,820.1 4,404.8 -43.7

Parts and accessories 10,012.0 9,339.0 4.3 5,692.8 3,605.5 -36.7 Motor vehicles for the transport of goods 9,351.1 7,376.8 3.4 4,534.6 2,907.2 -35.9 84.--nuclear reactors, boilers, machinery and mechanical appliances; parts thereof 24,808.4 24,739.9 11.4 14,898.1 11,899.1 -20.1

90.--optical, photographic, cinematographic, measuring, checking, precision, medical or surgical instruments and apparatus; parts and accessories thereof

7,550.7 7,516.4 3.5 4,444.9 4,088.7 -8.0

Subtotal 187,478.5 191,079.0 74.2 113,579.2 76,515.2 -32.6

Source: Author’s calculations based on USITC statistics (www.usitc.gov)

4. In the first and second quarters of 2009, imports contracted by 27.6 percent and more than 30 percent, respectively. All three product categories (consumption,

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intermediate, and capital goods) have been severely affected falling by 39.9 percent; 32.5 percent; and 30.1 percent, respectively, during the second quarter of the year. Unlike others countries, Mexico’s has not actively used trade instruments as a response to the international crisis.

Mexico’s integration process into the world economy

5. The severe impacts of the international crisis in Mexico’s trade reflect its deep integration to the world economy in general and to the U.S. market in particular. In the mid-eighties, as response to the debt crisis, Mexico undertook an in depth unilateral reform process that included its trade liberalization and accession to the GATT. According to the OECD, integration was an issue for Mexico’s growth before the 1990s, but because of the liberalization reforms undertaken in the 1980s and 1990s, lack of trade integration has ceased to be a major hindrance to growth for Mexico (OECD, 2009)86.

6. After a comprehensive unilateral liberalization process, Mexico adopted an active policy of trade negotiations that began with the signing of NAFTA and has continued until now. NAFTA was the first free trade agreement negotiated between a developing and two developed countries and established a new standard for trade liberalization that has been replicated—with some adjustments and updates—in a number of bilateral negotiations in different regions. So far, Mexico has concluded 12 preferential agreements with 44 countries, including the United States, the European Union, and Japan.

7. The Mexican Government is currently assessing its trade strategy towards the Asia-Pacific region and other emerging markets. The aim in the former case is to establish a coherent approach towards the faster growing region in the world. In the latter case, the main short run priority is to increase trade links between Brazil and Mexico, the two biggest economies of the Latin America region. In this case a joint committee to explore means to achieve this goal, including negotiating a free trade agreements, was created, and work is underway.

8. The overall reforms undertaken by Mexico resulted in an average expansion of exports of goods of 18 per cent between 1993 and 2000. The share of exports of goods and services in the GDP increased from less than 15 per cent to more than 31 percent in 200087. Trade growth, however, has weakened in the current decade falling to an average of 7 percent for the period between 2000 and 2008. The share of exports of goods and services in the GDP felt from 31 percent in 2000 to 28 percent in 2001 and has remained at that level since then. Mexico’s share in world trade has declined from 2.07 in the period 2000-2004 to 1.60 in 2006-200888.

86 OECD Mexico Economic Survey, July 2009, Volume 2009/11. 87 World Bank, World Development Indicators. 88 World Bank, World Trade Indicators.

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9. Between 2002 and 2006 Mexico adopted several trade initiatives to improve its competitiveness89. The most relevant were:

• In September 2002, tariffs for the electronics and high-tech industries (known as ITA Plus) were reduced establishing a tariff-free regime for 292 tariff lines which faced tariffs of 23, 18, 13 and 3 percent.

• In December 2004, an overall tariff reduction of 3 and 10 percentage points affecting 9,183 tariff lines took place.

• In September 2006, a new tariff reduction was enacted affecting 6,089 tariff fractions. According to the WTO, this measure reduced the average tariff rates from 16.5 per cent in 2001 to 11 per cent in 2008.

• Finally, Mexico merged the PITEX (Programas de Importación Temporal para Producir Artículos de Exportación and Maquila) and the Maquila Export Promotion in 2006 through the IMMEX Program (Programa para la Industria Manufacturera, Maquiladora y Servicios de Exportación). The PITEX program allowed companies that met certain minimum export requirements temporarily to import raw materials, parts and components duty-free and at a VAT rate of 0 per cent90. Under the new IMMEX program, the tariff on temporary imports of raw materials, parts and components is not paid as long as the inputs are incorporated into a product for export. It maintains a simplified administrative procedure for payment of income tax and other benefits concerning the fixed assets tax (IMPAC) that was available under the Maquila program.

10. Changes were also introduced in customs procedures. A special program for certified companies was established to accelerate customs formalities of high-volume exporting companies with a good fiscal and commercial track record. The program allowed certified companies to use reserved lanes leading to a reduction in procedures and inspection times. In addition, an Integrated Computerized Customs system was created to facilitate customs clearance for importers and exporters, enabling them to make their import and export requests electronically. Customs modernization efforts also included investment in customs infrastructure and technology, and training for customs officials91.

11. Despite these individual initiatives, Mexico liberalization has lagged behind on some fronts. The emphasis on bilateral trade agreements created a gap among the average bound tariff rate at the WTO92 (36.1 percent), the applied average Most Favored Nation

89 Opening Statement by the Representative of Mexico, 2008 Trade Policy Review Minutes of Meeting, WT/TPR/M/195, 14 April 2008, and WTO Secretariat Trade Policy Review. 90 Some FTAs signed by Mexico contains exceptions on the use of these incentives. 91 Opening Statement by the Representative of Mexico, 2008 Trade Policy Review Minutes of Meeting, WT/TPR/M/195. 92 Commitment not to increase a rate of duty beyond an agreed level. Once a rate of duty is bound, it may not be raised without compensating the affected parties.

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(MFN) rates93 for imports from countries without trade agreements, and the effective average tariff rate resulting from tariff preferences negotiated by Mexico. Table 3 shows that Mexico’s MFN tariff rate is relatively high compared to other emerging economies and OECD countries. In contrast, when preferential agreements are factored in, its average applied tariff rate is the lowest among this group of countries, except for high income OECD countries and Malaysia. Finally, Mexico’s overall trade restrictive index (OTRI) that includes both applied tariff and non-tariff measures is among the highest in this group of countries after Malaysia and Brazil94.

12. Mexico’s trading partners have expressed concern about its trade regime. In the context of the WTO’s Trade Policy Review of Mexico, which took place in 2008, members of the WTO "commended Mexico's commitment to trade liberalization, as demonstrated by its unilateral reduction of tariffs in 2006. However, Mexico was urged to continue simplifying its trade regulations and to reduce the gap between bound and applied tariffs in order to increase the predictability of its trade regime "95.

93 Duties that are actually charged on imports. These can be below the bound rates. 94 See among others Ministry of Economy (2004): Acciones concretas de la Subsecretaría de Industria y Comercio para incrementar la competitividad, www.economia.gob.mx/?P=12025 95 Trade Policy Review Mexico, Minutes of Meeting, WT/TPR/M/195, April 14, 2008.

Table 3: Tariff Rates in Selected Countries 2006-2008

Country TTRI

(MFN applied tariff)

TTRI (applied tariff, incl.

prefs)

OTRI (applied tariff, incl.

prefs+NTMs)

Country/Group

Mexico 13.14 3.75 18.03

Brazil 9.34 7.56 20.33

Latin America and Caribbean

7.84 5.36 11.46

East Asia- Pacific 4.89 4.70 12.91

Indonesia 4.63 4.47 7.47

Korea, Rep. 8.20 8.20 --

Malaysia 4.06 3.01 23.80

Thailand 6.57 6.65 8.69

High income OECDs

3.88 2.11 6.51

Source: World Bank, World Trade Indicators.

TTRI: This index summarizes the impact of each country's non-discriminatory trade policies on its aggregate imports. It is the uniform equivalent tariff that would maintain the country’s aggregate import volume at its current level. OTRI: This index summarizes the impact of each country's trade policies on its aggregate imports. It is the uniform equivalent tariff that would maintain the country’s aggregate import volume at its current level.

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13. The Mexican Government also identified important problems in its trading regime. According to a study by the Ministry of Economy, higher tariffs were applied to inputs than to final products resulting in negative effective protection, particularly when producers in countries with which Mexico has preferential agreements may import these inputs at lower rates and use them to produce goods that were subsequently exported to Mexico. Furthermore, the study considered that tariff reductions for the import of inputs and machinery allowed under the PROSECs (Programa de Promoción Sectorial) were not an optimal solution because of their administrative costs and their limited scope (Box 1). As a conclusion, the study proposed to lower MFN tariffs, particularly on raw materials, as they represent a cost disadvantage for Mexican companies.

Box 1: Specialized Tariff Reduction Schemes.

Under the PROSECs regime, created in November 2000, companies may import inputs, at a reduced tariff, within a range of 0 to 5 per cent, to produce goods for exports or the domestic market. Both the inputs imported and the goods produced are grouped by sector, the benefits of the program only apply to those inputs included in the sector in question and may not be used for other purposes.

Among the sectors that have used this program are: electricity; electronics; furniture; toys, games and sports articles; footwear; mining and metallurgy; capital goods; photography; agricultural machinery; chemicals; articles of rubber and plastic; iron and steel; medical equipment, medicines and pharmaceutical products; transport (except the automobile industry); paper and paper board; wood; hides and skins; the automobile industry and automobile parts; textiles and clothing; chocolates, confectionery and the like; coffee and various industries.

The Regla Octava provides tariff concessions for products not covered by the PROSECs. The imports of these products are administered through import licences under heading 98.02 of the tariff in the Law on General Import and Export Taxes TIGIE. The beneficiaries must have a program authorized by the Secretaria de Economia and meet the following criteria: non-existence or insufficiency of domestic production; diversification of sources of supply; the goods imported are required at a stage prior to the commencement of production under new projects; and the commercial obligations in international markets are respected.

Source: Mexico’s Trade Policy Review, Report by the WTO Secretariat, May 2008.

14. The Mexican Antitrust Commission, Comisión Federal de Competencia (CFC) also issued an opinion in May 2008 providing a critical assessment of Mexico´s trade regime. According to the CFC, the tariff structure discriminated between importers and created distortions that limited the ability of domestic producers to compete with their foreign competitors. This leads to low levels of efficiency, higher production costs and higher prices for consumers. The view of the competition authority was that the tariff structure should not create distortions in production and consumption decisions. The effective elimination of these distortions required to give all operators the right to access to international markets on a non-discriminatory basis.

15. Regarding non-tariff measures, the competition authority identified three main concerns in the Mexican regime: (a) customs procedures, including barriers to entry to customs-related services providers; (b) technical barriers to trade, including conformity assessment procedures; and (c) a lack of adequate resources in the customs agency for performing verifications. The competition authority concluded by identifying five areas

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that provided opportunities for further improvements: (a) reduce the level and dispersion of tariff structure; (b) simplify customs procedures; (c) eliminate barriers to entry for services related to customs procedures; and (d) strengthen the customs authority by providing adequate infrastructure and resources in line with its responsibilities and the needs of users.

16. Consistent with the aforementioned concerns, the Government issued a Decree on December 24, 2008, that rationalizes the MFN tariff structure for all non-agricultural products from an average of 10.4 percent to 4.3 percent in 2013 (Figure 2). It will also simplify the tariff structure from thirteen different levels to six. Overall, the reform rationalizes the tariff structure, reduces distortions and trade costs, and eliminates the negative effective protection that prevailed for some goods. The first phase of the reform was implemented on January 1st, 2009, reducing the average MFN rate on manufacturing products to 8.3 percent. The sharpest reduction will take place in January 2010 when the average MFN tariff on manufacturing products will fall to 5.2 percent. Products that will maintain a 20 percent tariff rate are concentrated in the following categories: apparel, leather manufactures and shoes, vehicles and auto parts, and chemical products, including pharmaceuticals. Products under the category of electrical machinery and equipment and parts will face tariffs of 10 or 15 percent. A recent OECD report considers that the “significant reductions in import tariffs should help the economy take fuller advantage of trade and investment integration, which could be a relative strength for Mexico given its geographic location”96.

17. What are the expected impacts of the reforms? The Bank’s view is that the impacts will depend mainly on the effect that the tariff reduction will have on the origin of imported goods. For those products in which imports come mainly from trade agreements and in which MFN tariffs are high, a reduction in the tariff may redirect imports to more efficient suppliers that have no trade agreements with Mexico such as East Asia trading partners. By reducing MFN tariffs, it would be expected that the diversion effects that Mexican FTAs may have created will be reduced, improving overall welfare and leading to a reduction in consumer costs. A 2004 study found that the Mexican tariff structure imposed welfare losses of US$2 billion to citizens (or 0.3 percent of GDP in 2004)97. The products identified in this category include: vehicles, electronics, equipment and machinery, chemical products, including pharmaceuticals, woods, furniture, and steel98. This does not mean that an import surge is likely to occur, particularly in the context of the current collapse in world trade; however, these industries probably will face more competition from a large number of suppliers--in particular from the Asia-Pacific region.

96 OECD Mexico Economic Survey, July 2009, Volume 2009/11. 97

World Bank (2006), Mexico’s Competitiveness: Reaching its potential; Finance, Private Sector, and Infrastructure Department. 98 Based on information provided by IQOM, Inteligencia Comercial, www.iqom.com.mex

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Figure 2: New Tariff Structure: Non-agricultural Products

18. Reforms will reduce trading costs to companies especially benefiting smaller companies. The enacted trade reform will simplify the operational costs of current users of certain special imports regime such as the Sectoral Promotion Programs (PROSECs) and the Regla Octava—described in Box 1—and reduce the costs of the agencies responsible for their administration and control. In addition, large and medium sized companies have been the main beneficiaries of these programs given the high administrative costs to access them. The tariff reduction makes the special imports regimes less attractive (or relevant) and the general import regime more accessible to all producers. Hence, the tariff reform is expected to widen access for small companies to more efficient inputs on a non-discriminatory basis increasing their competitiveness.

19. The impact on Mexican tax revenues is expected to be small. In terms of total tax revenues, tariff importance felt from a maximum of 10 percent in 1992 to 3.6 percent in 2008. Moreover, in terms of GDP its incidence was reduced from 1 percent to 0.3 percent during the same period.

Source: Own elaboration on the basis of information provided by IQOM Inteligencia Comercial.

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20. Additional reductions in trade costs are also a priority in the Government agenda, and the Government has already eliminated certain requirements in order to simplify and to facilitate trade. For example, importers are no longer required to deposit a security to ensure the price estimates by the SHCP of imported goods (WTO, Trade Policy Review Mexico, 2008). The Register of Importers in Specific Sectors was eliminated except for a few sectors, mainly related to national security. Now importers must be registered only in the Importers´ Register. Nevertheless, some problems remain in regard to the causes for cancellation of importers from the Register. In addition, certificates of origin validity were extended until the last working day of February 2010. The new certificates issued are valid for a period of 3 years, and the criteria to obtain an approved exporter certificate have been relaxed. New electronic certificates of origin are also in place for bilateral trade between Colombia and Mexico since August 2009. Finally, a digital system for registration of domicile for companies conducting operations with IMMEX programs was also implemented.99.

21. The Mexican authorities have identified other key areas where trade regulations should be streamlined and procedures rationalized. Among them it is worth mentioning: (a) pre-validation requirements; (b) barriers for the provision of customs related services; (c) the extent of customs agents’ powers; and (d) technical barriers to trade, including conformity assessments procedures. Mexico’s Customs Institutional Strengthening Project (Report Number 47396-MX) supported by the World Bank will address points (a), (b), and (c) with the specific goal of reducing costs and time of trade transactions in accordance with international practice and agreements. The project will also strengthen the implementation of a risk management system for customs merchandise and passengers. As Table 4 highlights, there is substantial scope for improving Mexico´s customs efficiency, which is well below the OECD countries´ average and slightly better that the Asian-Pacific economies.

22. Regarding technical barriers to trade, there are two types of problems. First, the number of agencies responsible for control and verification increases complexity and costs, in particular in the sanitary and phytosanitary area. Second, regarding conformity assessment procedures, barriers to entry reduce competition among services providers. The Government´s objective is to start addressing these matters in the near future. The establishment of a single window for trade transaction will provide a basis to start dealing with this aspect.

99 WTO Secretariat Mexico Trade Policy Review Report, WT/TPR/S/195/Rev.1.

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Table 4: Trade Facilitation Indicators (2006-2008)

Source: Doing Business, LPI, and World Trade Indicators.

Country/Group

LPI - Efficiency of

customs and other

border procedures

No. of

documents for

export

Days for

export

No. of

documents for

import

Days for

import

High income OECDs 3.59 4.4 23 4.92 10.64

East Asia- Pacific 2.41 6.95 22.57 7.5 27.45

Malaysia 3.36 7 33 7 14

Korea, Rep. 3.22 4 46 6 8

Thailand 3.03 4 26 3 13

Indonesia 2.73 5 20 6 27

Latin America and Caribbean 2.38 7 22.78 7.32 23.5

Brazil 2.39 8 14 7 19

Mexico 2.5 5 17 5 23

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ANNEX 6. POVERTY AND SOCIAL IMPACT REVIEW

Recent evolution of poverty and inequality in Mexico

1. After a decade of continuous decline, the most recent official figures show that Mexico has experienced an important increase in monetary poverty. Making use of the most recent household expenditure survey, CONEVAL has estimated that extreme poverty (pobreza alimentaria) increased from 13.8 to 18.2 percent of the national population between 2006 and 2008.100 Measures of moderate poverty (pobreza de capacidades and pobreza patrimonial) rose from 20.7 and 42.6 percent, respectively, to 25.1 and 47.4 percent in the same period. All measures of poverty increased in around 4.5 percentage points, which makes current figures to be the highest in record since year 2002 (see Figure 1).101

Figure 1: Mexico: Evolution of Income Poverty (1992- 2008)

Source: CONEVAL, Comunicado de Prensa No. 006/09, 18 de Julio 2009

100 CONEVAL stands for Consejo Nacional de Evaluación de la Política de Desarrollo Social. It is the Mexican institution, according to the Social Development Law, that produces the official estimates of poverty. 101 Three concepts of poverty (pobreza alimentaria, de capacidades and de patrimonio) are regularly computed in Mexico. Pobreza alimentaria refers to individuals or households unable to afford a basic basket of food products with the totality of their disposable income. Pobreza de capacidades refers to inadequacy of incomes to pay expenditures in health and in education, in addition to the basic food basket. Pobreza de patrimonio also includes inadequacy to afford expenditures in clothing, housing and transportation. In the urban area, the poverty lines for these concepts amount to 949.38, 1164.41 and 1904.84 monthly pesos per head, respectively (around US $ 90, 100 and 170, respectively). In the rural area, the poverty lines are 706.69, 835.52 and 1282.36, respectively (around US $ 65, 75 and 115, respectively)

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2. The new poverty rates also indicate increases in both urban and rural monetary poverty. Extreme poverty grew from 7.5 percent of the population in urban areas in 2006 to 10.6 percent in 2008 and from 24.5 percent to 31.8 percent in rural areas during the same period. This has meant an increase in 2.2 million new poor in urban areas and 2.8 million in rural areas. If pobreza de patrimonio is considered, then the urban rates grew from 35.6 percent in 2006 to 39.8 percent in 2008 and the rural rates from 54.7 percent to 60.8 percent during the same period. In absolute numbers, this implies an increase of 3.6 million new poor in rural areas and 2.3 million in urban areas (Table 1).

Table 1. Poverty Rates and Number of Poor in Mexico, 1992 - 2008

Source: CONEVAL. Comunicado de Prensa No. 006/09, 18 de Julio 2009

3. In terms of inequality, CONEVAL reports that the bottom decile of the population concentrates 1.4 percent of total income whereas the top decile has 39.3 percent of total income, in year 2008. The figures for 2006 were 1.6 and 39.3 respectively, which indicates a slight increase in inequality as measured by this indicator.

4. Interestingly, arguing in favor of the multidimensionality of poverty, CONEVAL also reports coverage in basic services (such as education, health and housing) and in social protection (access to social security and social assistance). In this regard, indicators of school attendance, life expectancy, child mortality, maternal mortality, and housing infrastructure (access to “piso firme”) show a favorable trend for the period 2006-2008. Although the share of household heads without access to a social security program increased from 71 to 72 percent, the percentage of households without coverage of any

Year

Alimentaria Capacidades Patrimonio Alimentaria Capacidades Patrimonio

National

1992 21.4 29.7 53.1 18.6 25.8 46.1

2000 24.1 31.8 53.6 23.7 31.2 52.7

2006 13.8 20.7 42.6 14.4 21.7 44.7

2008 18.2 25.1 47.4 19.5 26.8 50.6

Urban

1992 13.0 20.1 44.3 6.8 10.5 23.1

2000 12.5 20.2 43.7 7.5 12.1 26.2

2006 7.5 13.6 35.6 5.0 9.0 23.6

2008 10.6 17.2 39.8 7.2 11.7 27.2

Rural

1992 34.0 44.1 66.5 11.8 15.3 23.0

2000 42.4 49.9 69.2 16.2 19.1 26.5

2006 24.5 32.7 54.7 9.4 12.6 21.1

2008 31.8 39.1 60.8 12.2 15.0 23.4

Headcount rates million of people

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social program declined from 50.1 to 44.1, in the period of reference.102 This indicates that other welfare indicators have not shown the same trend than monetary poverty and that the Mexican Government has been successful in expanding the coverage of social protection.

5. The results in terms of monetary poverty and inequality can be the consequence, among many other things, of the food prices crisis that shocked the world economy during 2007 and early 2008. However, the impact of the current global crisis is not registered in these numbers because the reference survey collected information in August 2008. The global crisis affected Mexico since the last quarter of 2008 when there was a net job destruction for the first time in several years and output declined by 1.6 percent (year-to-year). Furthermore, the most severe impact of the crisis was felt in the first half of 2009, when unemployment rose to 6.28 percent (August 2009) and GDP fell by more than 8 percent for two consecutive quarters. This dire economic performance is likely to produce a further upward impact on monetary poverty and inequality figures for year 2009. Given the depth of the crisis, there may also be a stop in the advances in social development or even deterioration in these if the duration of the crisis lengthens more than expected.

6. Recent studies indicate that growth-elasticity of poverty lies in the range of [-5.0, -0.5] depending on method and sample of countries.103 Consequently, an economic downturn for year 2009 of around 6 percent, could lead to an increase in poverty rates of 3 to 30 percent, that is (using the extreme poverty measures for 2008) an increase between half a percentage point and five percentage points. Historical evidence from the previous “Tequila” crisis shows that extreme poverty rose from 21.2 percent to 37.4 percent between 1994 and 1996 (a period when growth declined 7.0 percent in 1995 and then rebound 7.1 percent in 1996). The massive expansion of poverty during that crisis led to the introduction of innovative social programs, and a series of political and economic reforms that allowed for a continuous reduction of poverty between 1996 and 2006. Currently, Mexico has a battery of instruments to prevent the repetition of the 1995 experience.

7. In response to the deep and rapidly deteriorating situation of the economy, the Mexican Government has adopted a series of measures in several areas. Most of these policies take advantage of the process of modernization of the Mexican economy and institutions that the country has undergone in the last two decades. Some policies seek to correct fiscal imbalances, others to strengthen the financial and business sectors and yet others to protect families standards of living. Some of these policies aim at producing a rebound in economic growth and others at protecting the most vulnerable groups of the population. The latter have, therefore, an explicit social protection objective. Among the

102 Social security coverage for household heads refers to being a beneficiary of the programs of IMSS, ISSTE, PEMEX, Marina (Navy), Ejército (Army) and Universities. Household without coverage of social program refers to a household without access to Oportunidades or Procampo, no member is affiliated to Seguro Popular and household head does not have access to health coverage as job benefit. 103 See, for instance, Haughton and Kandker (2009) or Adams (2004)

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crisis impact mitigating policies with an explicit social protection objective are the Fiscal reform with 2010 budget proposal and the labor market polices included in the Employment pillar of the ANFEFE.

Fiscal policies

8. The most important fiscal policy measure of the Program is the budget proposal for 2010 which includes a series of changes in new and existing taxes that seeks to increase non-oil revenues for the central government. These taxes are accompanied by an important expansion of the most important social program in Mexico (the conditional cash transfer program Oportunidades). The combination of these two broad sets of policies has interesting distributive consequences.

9. The new taxes proposed for fiscal year 2010 onwards include: a new excise tax on telecommunications services (4%) and increases in excise taxes (IEPS) from tobacco, beer, alcoholic beverages and games and lotteries. It also includes changes in the income taxes through an increase in the corporate rate, changes in consolidation practices, an increase in personal income top bracket (of 2 percentage points) and a reduction in the minimum level for tax exemption. Furthermore, a new consumption tax (in a non-cumulative way, allowing for credits) of 2% on all goods and services.

10. The new consumption tax, the most controversial given past attempts to broaden the base of the existing VAT in Mexico, is argued to finance in part an expansion of the Oportunidades program in 800 thousand new families. The whole tax program is also intended to finance expansion of other social programs such as the Programa Alimentario (PAL) and the Seguro Popular.

Table 2. Estimates of Annual Tax Collection for Eligible Oportunidades Beneficiaries

Source: SHCP

11. A preliminary evaluation of the distributive impact of the budget proposal has been produced by the Secretaría de Hacienda y Credito Publico (SHCP). In this evaluation, it is assumed that the new consumption (as well as the new or increased excise taxes) is fully paid by consumers (i.e., the tax incidence falls fully in consumers, as if demand were perfectly inelastic) and that all consumers actually buy their products in formal markets that comply with the new tax code. These are conservative estimates, because it is plausible to assume that not all the new tax is passed through to consumers and consumers in the bottom of the distribution are less likely to purchase goods from formal, fully tax compliant retailers. Given the share of tobacco, beer and other alcoholic

million pesos pesos per family

Nex excise taxes 215.5 269.2

New consumption taxes 655.9 819.9

Tax administration 172.2 215.3

Total 1043.6 1304.4

Tax Collection

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beverages and lotteries consumption within total consumption for those households in the bottom of the income distribution (approximately the three bottom deciles) and assuming that these households total consumption is equal to their total income (i.e., they have little or no savings whatsoever), the total and per-household new tax collection is computed to be of 1,043.5 million pesos and 1,304 pesos, respectively (Table 2). Given that the total estimated tax collection amounts to 192.3 billion pesos, it can be said the poorest members of the Mexican society only contribute in 0.5% of the total, which indicates that the proposal is very progressive in terms of absolute incidence.

12. Making some additional assumption about the average benefit that beneficiaries from Oportunidades, new and old, will receive (approximately 26.2 percent of the annual income of households in the two-three bottom deciles of the distribution), SHCP has estimated the average transfer to be received by these families. This transfer amounts, they reckon, to 12,577 pesos per year, per beneficiary family. Given the annual tax collection of 1,304 pesos hypothesized for this group, it can be said that the families in the bottom of the distribution will receive a net transfer of 11,273 pesos per year.

13. The complete distributional impact of the fiscal program, however, requires an assessment of the transfers, both in cash and in kind, that other groups in the income distribution may receive in year 2010. The expansion of Seguro Popular and of PAL, is likely to favor groups in both the bottom and the middle of the distribution. The temporary expansion of health and maternity benefits (see next section) is likely to benefit families in the middle of the income distribution. In any case, households in the middle of the distribution are likely to receive less generous transfers than those in the bottom, and given their relatively higher proportion of consumption than those in the top of the distribution, it is plausible that middle income households will have a larger relative incidence than other income groups of the consumption tax. To complement this, it should also be said that families in the top of the distribution will perhaps receive no transfers from the social programs mentioned above and will have to pay both the consumption and excise taxes as well as the expansion of income taxes. This latter component is likely to have a large absolute and relative incidence on families in the top of the distribution. The final relative incidence of the whole package will depend on adding all the tax and transfer effect in each social group. This is an empirical question that requires additional scrutiny.

14. Even though, a preliminary evaluation of the net impact of the program seems to indicate that absolute incidence is favorable to those in the bottom of the distribution, it is also necessary to investigate the relative and absolute incidence of the whole package. This, however, requires to compute how all the taxes (consumption, excise and income taxes) affect middle and top deciles of the distribution, as well as the transfers both in cash and in kind, that different groups will receive from the next budget. In summary, the present preliminary evaluation of the net impact must be complemented at a further

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stage104 with a rigorous analysis of the taxes’ absolute and relative incidence along the income distribution.

Labor market policies

15. On January 7, 2009, President Calderón announced to the Nation the content of the National Agreement in Favor of the Family Economy and Employment (ANFEFE--Acuerdo Nacional a Favor de la Economía Familiar y el Empleo). The agreement includes a series of policy actions to be adopted by the Federal Government during fiscal year 2009, as well as a string of commitments on the part of several public and private Mexican institutions. Policy actions by the Federal Government included in the agreement are grouped into five pillars. The first pillar, Support to Employment (Apoyo al Empleo y a los Trabajadores) is a combination of both active and passive labor market policies to confront the international crisis.

16. The Programa de Empleo Temporal (PET) and the Servicio Nacional de Empleo (SNE) are the two main active labor market polices proposed in the ANFEFE. The former is an emergency employment program that provides temporary employment to workers out of work, or with reduced income, due to a natural emergency or limited employment opportunities due to a fall in labor demand. SNE is a umbrella of programs that includes both labor intermediation, mobility and training services.

17. Temporary employment programs are considered an appropriate mechanism for dealing with cyclical downturns in the labor market. They provide an income support for those who lost their job and, given their self-targeting mechanism (they usually pay below minimum or nearly minimum wages), they focus on those most in need of finding an income source. In addition since they are not tied to social security contributions or any other previous employment requirement, temporary employment programs are expected to benefit those in the bottom of the income distribution. The international impact evaluation literature finds that these programs have only short term employment impacts and no wage/productivity impact for the beneficiaries.105 The Latin American literature for this type of programs finds positive short-term employment effects.106 This evidence confirms the anti-cyclical, temporary, emergency character of the program.

18. For the case of the Mexican program PET, there are very few evaluations available. One evaluation done in 2002 (cited by Samaniego, 2002) recorded that the program was effective in helping 60% of its beneficiaries escaping poverty. A more recent performance evaluation done by FAO (2007) highlighted that the program had problems in design and targeting of beneficiaries. In a similar vein, the most recent evaluation by CONEVAL (2008) also remarks the lack of recent and thorough program evaluations of PET. CONEVAL acknowledges the wide geographic coverage of the

104 Further work on a full Poverty and Social Impact Assessment (PSIA) of the policies will be carried out by Bank staff together with government counterparts during program implementation. 105 For a summary of temporary employment programs in developed countries see Kluve (2006), Kluve et al (2005), Betcherman et al. (2004) and Estevao (2003) 106 See Landa and Lizarraga (2007), Jalan and Ravallion (2002) and Samaniego (2002)

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program but highlights problems in both program design, selection of beneficiaries, objectives and quantitative indicators and targets. The administrative reform of the program (described in Annex 5c) is a response to this recent CONEVAL report.

19. Despite its problems, it can be argued that PET is a potentially useful and adequate mechanism for dealing with the current crisis.107 Some authors argue that PET is a flexible and appropriate program for dealing with the cyclical aspect of this crisis (in contrast to other programs like Oportunidades, which deal with more long term, structural poverty). In addition to its short-term benefits in terms of employment, it could be argued that the programs may also have long-term, indirect benefits in terms of community infrastructure in poor backward regions. Scott (2009) argues that PET is one of the most progressive social programs in Mexico, only after Oportunidades and Piso Firme (Table 3).

Table 3. Targeting of Oportunidades, PET and other Targeted Social Programs

Source: Scott, J (2009) Notes: (*) Value in parenthesis includes the indirect benefits to the poor from the outputs of the projects in addition to wage transfers (**) Productive Options and microregions.

20. Regarding the effectiveness and distributive impact of training and intermediation programs, there is also a vast literature.108 The literature of developed and transition economies find that intermediation services are an effective means for helping job seekers find a job. The studies for Latin America, however, do not find a favourable evidence in this regard due, perhaps, to the usual reliance on informal methods (word of mouth, family contacts, self employment) of job search that predominate in the region. An intermediation service for which there is an impact evaluation is the Brazilian SINE. This evaluation reports that the program has a positive impact in finding a formal job.109 Evaluations of training programs, on the other hand, show more diverse results. Training programs for adults show mixed results depending on country and methodology while training programs for youth show no favorable results in developed countries (with the exception of Job Corps in the USA) and positive results for Latin American countries (the Jóvenes type program).110

21. For the case of the Mexican program SNE, which encompasses both labor intermediation and training programs, there are several evaluations regarding the latter

107 This paragraph benefits from the presentation “Mexico’s Programa de Empleo Temporal. Evaluation and Reforms” given by prof. John Scott to the Levy Economics Institute on June 23, 2009. 108 See Betcherman at al. (2004), Kluve et al (2005) Boon and Van Ours (2004) 109 See Wolterman (2002). 110 See Betcherman et al. (2004), Kluve et al. (2005), Kluve (2006) and Porto and Puerto and Fares (2009)

Objective

Population PET* Oportunidades Other targeted

Other targeted

productive **

poorest 20% 44% 54.50% 22.00% 13%

poorest 40% 66% 82.70% 43.30% 21%

Targeting

(% transfer

received by

poor)

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component. Most of these evaluations find that the program has a favorable impact on short and long-term employment, but no significant impact on wages. The most recent evaluation report by CONEVAL to the Progama de Apoyo al Empleo (PAE, one of the sub-programs within the SNE) also confirm the findings of previous studies: training programs in Mexico (BECATE in particular) have a positive effect on the probability of finding employment, although no significant, or ambiguous, effect on salaries.111 Several evaluations, both recent by CONEVAL and previous, usually find a larger positive impact among women and among those with less formal education. Given the fact that women and those with less formal education have, on average, lower earnings it can be said that these training programs have progressive impact that benefits more to those in the bottom of the earnings distribution.

22. The passive labor market policies included in the ANFEFE are two: i) expanded withdrawals from pension savings accounts for unemployed workers and ii) extended coverage of health and maternity benefits for unemployed workers who contributed to the system. The latter is a temporary measure that protects workers and their families during what can be expected to have been the worst period of the crisis (first and second quarters of 2009). The former is a permanent change with long term implications.112 The short-term distributive impact of these policies can be expected to be favorable to middle income families. In fact, both measures are linked to being a beneficiary of the formal social security systems in Mexico, particularly the Instituto Mexicano del Seguro Social (IMSS). In this regard, as Figure 2 shows, beneficiaries of the IMSS are concentrated in the middle and top deciles of the income distribution, hence allowances to withdraw from pension funds and extended coverage of health insurance will have a larger likelihood to occur in middle and top deciles of the distribution. If unemployment concentrates in lower-middle income households (as some preliminary evidence from CONSAR indicates, see Annex 5.c) then it can be hypothesized that this policy will have a distributive impact favorable to those in the middle of the income distribution in the short term. Notwithstanding that the expanded withdrawals from individual retirement accounts allowed the Government a rapid response to an increasing problem of unemployment due to the global crisis, there might be a need for a broader review of passive labor market policies in the medium term since the current provision raises a threat of eroding workers’ pension funds.

111 See, among others, Revenga, Tyboud and Tan (1992), Wodon and Minowa (1999), Delajara et al (2007). 112 The analysis of the long term implications, regarding the impact of these withdrawals on accumulated pension savings towards the end of the working life is beyond the scope of this Annex.

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Figure 2. Health Insurance Coverage via Seguro Popular and IMSS

Source: Staff calculations, based on ENIGH 2006. Notes: (1) A household is classified as “insured” here if at least one of its members is covered by any of social security schemes such as IMSS, ISSSTE, PEMEX, the Armed Forces, universities or private health insurance. (2) The data indicate a very small level of overlap between being covered by health insurance via social security and being covered by Seguro Popular; less than one percent of households in all deciles report being both “insured” and also part of Seguro Popular.

Trade integration policies

23. The tariff reform is expected to reduce costs to consumers. However, a full welfare gains analysis requires an evaluation of wage and employment gains and losses, as well as its distribution. According to the authorities the productive sectors that will benefit from the tariff reforms are mainly the agricultural, construction, and services sectors that generate 85.7 percent of total employment. Within these, SMEs are expected to benefit more in relative terms given that it had been relatively more costly for them to access the special imports regimes. Regarding the manufacturing sector, the authorities expect that the potentially affected companies comprise 14.3 percent of total employment113. The activities that could be negatively affected are textiles industries, plastics, metal products, leather products, paper, printing and related industries, chemicals, wood industry, and oil and coal related industries. Several of these industries have experienced a fall in their participation in total manufacturing employment and value added prior to the crisis. The recent expansion of active labor market programs

113 Information provided by the Ministry of Economy.

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(especially the temporary employment program, the retraining program, and job networking) supported by the third pillar of this operation will provide assistance to workers that might be adversely impacted by the tariff reform

Conclusion

24. The response to the international crisis by the Mexican Government includes a series of policies that have an explicit social protection objective. Among them is the fiscal reform contained in the 2010 budget proposal and the labor market polices included in the Employment Pillar of the ANFEFE. A preliminary analysis of these measures indicates that they may have a favorable impact in the lower and middle ranks of the earnings/income distribution.

25. The expansion and administrative improvements of existing labor market policies, together with the introduction of an important fiscal reform, shows the capacity of the Mexican Government to rapidly confront the severe crisis that the economy is undergoing, while making at the same time what appear to be, after preliminary study, distributionally sensible economic policies.

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REFERENCES

Adams, Richard H. (2004) “Economic Growth, Inequality and Poverty: Estimating the Growth Elasticity of Poverty”, World Development, Volume 32, Issue 12, December 2004, Pages 1989-2014.

Betcherman, Gordon, K. Olivas, and A. Dar (2004) “Impacts of Active Labor Market Programs: New Evidence from Evaluations with Particular Attention to Developing and Transition Countries”, The World Bank, Social Protection Discussion Paper Series, No. 0402.

Boon, Jan and J. Van Ours (2004) “Effective Active Labor Market Policies”, IZA Discussion Papers No. 1335.

CONEVAL, Consejo Nacional de Evaluación de la Política de Desarrollo Social (2009), Press Release No. 006/09 July 18, 2009.

CONEVAL, Consejo Nacional de Evaluación de la Política de Desarrollo Social (2008), “Programa de Empleo Temporal: Informe de la Evaluación Específica de Desempeño 2008”.

Delajara, M., S. Freije and I. Soloaga (2006) “An Evaluation of Training for the Unemployed in Mexico”, September 2006,Working Paper, Inter-American Development Bank.

Houghton, J. and S. Khandker (2009), Handbook on Poverty and Inequality, The World Bank.

Hanson, G. and A. Harrison (1999) “Inequality and Trade Liberalization and Wage Inequality in Mexico”, Industrial and Labor Relation Review, 52-2 .

Jalan, J and M. Ravallion (2002) “Estimating the Benefit Incidence of an Antipoverty Program by Propensity-Score Matching”, Journal of Business and Economic Statistics.

Kluve, J. (2006) “The effectiveness of European Active Labor Market Policy”, Institute for the Study of Labor, IZA Discussion Paper, No. 2018.

Kluve, J., D. Card, M. Fertig, M. Gora, L. Jacobi, P. Jensen, R. Leetmaa, L. Nima, E. Patacchini, S.Schaffner, C.M. Schmidt, B. van der Klaauw and A. Weber (2005) “Study on the effectiveness of ALMPs”, Report prepared for the European Commission, DG Employment, Social Affairs and Equal Opportunities.

Landa, F. and S. Lizárraga (2007) “Evaluación de Impacto del PLANE III: un programa que permitió adquirir experiencia laboral a los obreros”, Unidad de Análisis de Políticas Sociales y Económicas, Análisis Económico, Vol. 22, pp. 109-142.

Puerto, O.S. and J. Fares (2009) “Towards comprehensive training”, Paper presented at 4th IZA/World Bank Conference, Bonn, May 4-6, 2009.

Revenga, A, J. Ribaud and H. Tang (2004) “The Impact of Mexico's Retraining Program on Employment and Wages”, World Bank Economic Review.

Samaniego, Norma (2002) “Las Políticas de Mercado de Trabajo y su Evaluación en América Latina”, CEPAL, Serie Macroeconomía y Desarrollo, No.19.

Scott, John (2009) “México’s Programa de Empleo Temporal: Evaluation and Reforms”, Presentation to the seminar “Responding to the Current Economic Crisis and Contributing to Long Term Development”, UNDP-Levy Economics Institute, New York, June 22-23, 2009.

Woltermann, S. (2002) Ibero-America Institute for Economic Research, Georg-August Universitat, Discussion Paper, No. 98, Goetingen.

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Wodon Q. and Minowa M.(1999) “Training for the Urban Unemployed: a reevaluation of Mexico’s training program, PROBECAT”, Government Programs and Poverty in Mexico, Report 19214-ME, The World Bank.

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ANNEX 7. MEXICO AT A GLANCE

Mexico at a glance 7/20/09

Latin Upper

Key Development Indicators America middle

Mexico & Carib. income

(2008)

Population, mid-year (millions) 106.4 563 823

Surface area (thousand sq. km) 1,964 20,421 41,497

Population growth (%) 1.0 1.2 0.6

Urban population (% of total population) 77 78 75

GNI (Atlas method, US$ billions) 1,061 3,833 7,472

GNI per capita (Atlas method, US$) 9,980 6,780 7,878

GNI per capita (PPP, international $) 14,270 10,309 12,297

GDP growth (%) 1.3 4.2 5.8

GDP per capita growth (%) 0.3 2.9 5.1

(most recent estimate, 2000–2007)

Poverty headcount ratio at $1.25 a day (PPP, %) 2 8 ..

Poverty headcount ratio at $2.00 a day (PPP, %) 5 18 ..

Life expectancy at birth (years) 75 73 70

Infant mortality (per 1,000 live births) 29 22 22

Child malnutrition (% of children under 5) 3 5 ..

Adult literacy, male (% of ages 15 and older) 93 91 94

Adult literacy, female (% of ages 15 and older) 90 89 92

Gross primary enrollment, male (% of age group) 114 120 112

Gross primary enrollment, female (% of age group) 111 116 109

Access to an improved water source (% of population) 95 91 95

Access to improved sanitation facilities (% of population) 81 78 83

Net Aid Flows 1980 1990 2000 2007 a

(US$ millions)

Net ODA and official aid 55 156 -56 247

Top 3 donors (in 2006):

United States 9 23 24 154

Germany 15 9 15 26

France 15 51 -11 22

Aid (% of GNI) 0.0 0.1 0.0 0.0

Aid per capita (US$) 1 2 -1 2

Long-Term Economic Trends 1980 1990 2000 2008

Consumer prices (annual % change) 26.3 26.7 9.5 5.1

GDP implicit deflator (annual % change) 33.4 28.1 12.1 6.6

Exchange rate (annual average, local per US$) 0.0 2.8 9.5 11.2

Terms of trade index (2000 = 100) 194 106 100 116

1980–90 1990–2000 2000–08

Population, mid-year (millions) 67.6 83.2 98.0 106.4 2.1 1.6 1.0

GDP (US$ millions) 194,357 262,710 581,426 1,085,951 1.1 3.1 2.7

Agriculture 9.0 7.8 4.2 3.8 0.8 1.5 2.1

Industry 33.6 28.4 28.0 37.1 1.1 3.8 1.9

Manufacturing 22.3 20.8 20.3 18.8 1.5 4.3 1.8

Services 57.4 63.7 67.8 59.1 1.4 2.9 3.1

Household final consumption expenditure 65.1 69.6 67.0 65.5 1.4 2.3 3.8

General gov't final consumption expenditure 10.0 8.4 11.1 10.3 2.4 1.8 0.4

Gross capital formation 27.2 23.1 23.9 26.4 -3.3 4.7 1.5

Exports of goods and services 10.7 18.6 30.9 28.3 7.0 14.6 5.7

Imports of goods and services 13.0 19.7 32.9 30.5 1.0 12.3 6.3

Gross savings 22.0 20.3 20.5 24.9

Note: Figures in italics are for years other than those specified. 2008 data are preliminary. .. indicates data are not available.

a. Aid data are for 2006.

Development Economics, Development Data Group (DECDG).

(average annual growth %)

(% of GDP)

15 10 5 0 5 10 15

0-4

10-14

20-24

30-34

40-44

50-54

60-64

70-74

80+

percent

Age distribution, 2007

Male Female

0

10

20

30

40

50

60

1990 1995 2000 2006

Mexico Latin America & the Caribbean

Under-5 mortality rate (per 1,000)

-10

-8

-6

-4

-2

0

2

4

6

8

90 95 00 05 08

GDP GDP per capita

Growth of GDP and GDP per capita (%)

- 135 -

Mexico

Balance of Payments and Trade 2000 2008

(US$ millions)

Total merchandise exports (fob) 166,455 291,807

Total merchandise imports (cif) 174,458 308,645

Net trade in goods and services -10,661 -23,844

Current account balance -18,684 -15,527 as a % of GDP -3.2 -1.4

Workers' remittances 6,573 25,145

Reserves, including gold 35,585 95,302

Central Government Finance

(% of GDP)

Current revenue (including grants) 21.4 23.6

Tax revenue 10.6 8.2

Current expenditure 20.1 19.3

Technology and Infrastructure 2000 2007Overall surplus/deficit (PSBR) -3.4 -2.1

Paved roads (% of total) 32.8 37.0

Highest marginal tax rate (%) Fixed line and mobile phone

Individual 40 28 subscribers (per 100 people) 27 84

Corporate 35 28 High technology exports (% of manufactured exports) 22.4 18.9

External Debt and Resource Flows 2000 2007

Environment(US$ millions)

Total debt outstanding and disbursed 150,901 178,108 Agricultural land (% of land area) 55 55

Total debt service 58,509 40,301 Forest area (% of land area) 33.7 33.0

Debt relief (HIPC, MDRI) – – Nationally protected areas (% of land area) .. 5.3

Total debt (% of GDP) 26.0 17.4 Freshwater resources per capita (cu. meters) .. 3,967

Total debt service (% of exports) 30.4 12.5 Freshwater withdrawal (% of internal resources) 19.1 ..

2000 2008Foreign direct investment (net inflows) 17,942 18,589 CO2 emissions per capita (mt) 4.3 4.3

Portfolio equity (net inflows) 447 -3981

GDP per unit of energy use

(2005 PPP $ per kg of oil equivalent) 7.1 6.6

Energy use per capita (kg of oil equivalent) 1,534 1,712

World Bank Group portfolio 2000 2008

(US$ millions)

IBRD

Total debt outstanding and disbursed 11,444 5,769

Disbursements 1,748 1,940

Principal repayments 1,330 600

Interest payments 890 200

IDA

Total debt outstanding and disbursed 0 0

Disbursements 0 0

Private Sector Development 2000 2008 Total debt service 0 0

Time required to start a business (days) – 28 IFC (fiscal year) 2000 2007Cost to start a business (% of GNI per capita) – 12.5 Total disbursed and outstanding portfolio 1,234 1,184

Time required to register property (days) – 74 of which IFC own account 723 798

Disbursements for IFC own account 179 209

Ranked as a major constraint to business 2000 2007 Portfolio sales, prepayments and

(% of managers surveyed who agreed) repayments for IFC own account 66 134

Anticompetitive or informal practices .. 19.0

Corruption .. 17.8 MIGA

Gross exposure – –

Stock market capitalization (% of GDP) 21.5 38.8 New guarantees – –

Bank capital to asset ratio (%) 9.6 13.2

Note: Figures in italics are for years other than those specified. 2008 data are preliminary. 7/20/09

.. indicates data are not available. – indicates observation is not applicable.

Development Economics, Development Data Group (DECDG).

Bilateral, 1,895

Private, 158,091

Other multi-

lateral, 4,576IBRD, 4,540

Composition of total external debt, 2007

US$ millions

Short term

9,006

- 136 -

Millennium Development Goals Mexico

With selected targets to achieve between 1990 and 2015(estimate closest to date shown, +/- 2 years)

Goal 1: halve the rates for extreme poverty and malnutrition 1990 1995 2000 2007

Poverty headcount ratio at $1.25 a day (PPP, % of population) .. .. .. ..

Poverty headcount ratio at national poverty line (% of population) .. .. 24.2 17.6

Share of income or consumption to the poorest qunitile (%) 3.2 4.3 3.9 4.6

Prevalence of malnutrition (% of children under 5) 13.9 .. 6.0 3.4

Goal 2: ensure that children are able to complete primary schooling

Primary school enrollment (net, %) 98 .. 97 98

Primary completion rate (% of relevant age group) 86 95 99 104

Secondary school enrollment (gross, %) 53 .. 72 87

Youth literacy rate (% of people ages 15-24) 95 96 97 98

Goal 3: eliminate gender disparity in education and empower women

Ratio of girls to boys in primary and secondary education (%) 97 .. 99 99

Women employed in the nonagricultural sector (% of nonagricultural employment) 37 36 37 39

Proportion of seats held by women in national parliament (%) 12 14 18 23

Goal 4: reduce under-5 mortality by two-thirds

Under-5 mortality rate (per 1,000) 52 45 38 35

Infant mortality rate (per 1,000 live births) 42 36 32 29

Measles immunization (proportion of one-year olds immunized, %) 75 90 96 96

Goal 5: reduce maternal mortality by three-fourths

Maternal mortality ratio (modeled estimate, per 100,000 live births) .. .. .. 60

Births attended by skilled health staff (% of total) .. 86 .. 93

Contraceptive prevalence (% of women ages 15-49) .. 67 70 71

Goal 6: halt and begin to reverse the spread of HIV/AIDS and other major diseases

Prevalence of HIV (% of population ages 15-49) .. .. 0.3 0.3

Incidence of tuberculosis (per 100,000 people) 61 44 32 20

Tuberculosis cases detected under DOTS (%) .. 13 64 99

Goal 7: halve the proportion of people without sustainable access to basic needs

Access to an improved water source (% of population) 88 90 93 95

Access to improved sanitation facilities (% of population) 56 66 76 81

Forest area (% of total land area) 35.5 34.6 33.7 33.0

Nationally protected areas (% of total land area) .. .. .. 5.3

CO2 emissions (metric tons per capita) 5.0 4.4 4.3 4.3

GDP per unit of energy use (constant 2005 PPP $ per kg of oil equivalent) 6.1 6.2 7.1 6.6

Goal 8: develop a global partnership for development

Telephone mainlines (per 100 people) 6.4 9.7 12.6 18.8

Mobile phone subscribers (per 100 people) 0.1 0.8 14.4 64.8

Internet users (per 100 people) 0.0 0.1 5.2 21.7

Personal computers (per 100 people) 0.8 2.6 5.8 14.4

Note: Figures in italics are for years other than those specified. .. indicates data are not available. 7/20/09

Development Economics, Development Data Group (DECDG).

Mexico

0

25

50

75

100

125

2000 2002 2004 2006

Primary net enrollment ratio

Ratio of girls to boys in primary &secondary education

Education indicators (%)

0

10

20

30

40

50

60

70

80

90

2000 2002 2004 2006

Fixed + mobile subscribers

Internet users

ICT indicators (per 100 people)

0

25

50

75

100

1990 1995 2000 2006

Mexico Latin America & the Caribbean

Measles immunization (% of 1-year olds)

MAP SECTION

Citlaltépetl (5,747 m)

Si e r r a

Ma

dr e O

c c i d e n t a l

S ierra Madre del Sur

Si e

r r a M

ad

r e O

r i e nt a

l

CAMPECHE

CHIAPAS

TABASCO

OAXACA

GUERRERO

COLIMA

JALISCO

NAYARIT

ZACATECAS

TAMAULIPAS

NUEVOLEON

C O A H U I L A

C H I H U A H U ASONORA

D U R A N G O

SAN LUISPOTOSI

MICHOACAN PUEBLA

VERACRUZ YUCATAN

QUINTANAROO

S INA

LOA

Mazatlán

TorreónMatamoros

Laredo

Ojinaga

Los Mochis

Navojoa

NogalesSan

Felipe

Loreto

Sonoita

AguaPrieta

Guaymas

Tehuantepec

Frontera

Villahermosa

TuxtlaGutierrez

Oaxaca

Chilpancingo

Colima

Guadalajara

Tepic

Durango

Saltíllo

Chihuahua

Culiacán

Hermosillo

Mexicali

Guanajuato

Pachuca

Aguascalientes

Querétaro

MoreliaToluca

Cuernavaca Puebla

Tlaxcala

Jalapa

San LuisPotosí

CiudadVictória

Zacatecas

Monterrey

MEXICOCITY

Yaqui

Rio Bravo

Fuerte

Salado

Lerma

Balsas

Conchos

BAJACALIFORNIA

BAJACALIFORNIA

SUR

MEXICO

MORELOS

DISTRITO FEDERAL

HIDALGOGUANAJUATO

AGUASCALIENTES

TLAXCALA

QUERÉTARO

Usumacinta Rio Grande

GUATEMALATapachula

PuertoEscondido

Acapulco

Puerto Vallarta

Mazatlán

TorreónMatamoros

Laredo

Ojinaga

Los Mochis

Navojoa

Nogales

Ensanada

Tijuana

SanFelipe

SantaRosalia

Loreto

Cabo San Lucas

Sonoita

AguaPrieta

Ciudad Juárez

Guaymas

Veracruz

Tampico

Tehuantepec

Cozumel

Cancun

Frontera

Chetumal

Merida

Villahermosa

Campeche

TuxtlaGutierrez

Oaxaca

Chilpancingo

Colima

Guadalajara

Tepic

Durango

Saltíllo

Chihuahua

Culiacán

Hermosillo

Mexicali

La Paz

Guanajuato

Pachuca

Aguascalientes

Querétaro

MoreliaToluca

Cuernavaca Puebla

Tlaxcala

Jalapa

San LuisPotosí

CiudadVictória

Zacatecas

Monterrey

MEXICOCITY

CAMPECHE

CHIAPAS

TABASCO

OAXACA

GUERRERO

COLIMA

JALISCO

NAYARIT

ZACATECAS

TAMAULIPAS

NUEVOLEON

C O A H U I L A

C H I H U A H U A

BAJACALIFORNIA

BAJACALIFORNIA

SUR

SONORA

D U R A N G O

SAN LUISPOTOSI

MICHOACAN

MEXICO

MORELOS

DISTRITO FEDERAL

PUEBLA

HIDALGOVERACRUZ

GUANAJUATO

AGUASCALIENTES

TLAXCALA

YUCATAN

QUINTANAROO

S INA

LOA

QUERÉTARO

UNITED STATES OF AMERICA

GUATEMALA

BELIZE

HONDURAS

ELSALVADOR

Yaqui

Rio Grande

Rio Bravo

Fuerte

Salado

Lerma

Balsas

Usumacinta

Conchos

PACIFICOCEAN

Gulf of Mexico

Bay of Campeche

Gulf ofTehuantepec

Gulf of

Honduras

Gu

l f of C

al i f o

r ni a

To Los Angeles

To Gila Bend

To Albuquerque

To Alamogordo

To Midland

To San Antonio

To San Antonio

To Houston

To San Salvador

Si e r r a

Ma

dr e O

c c i d e n t a l

S ierra Madre del Sur

Si e

r r a M

ad

r e O

r i e nt a

l

Citlaltépetl (5,747 m)

115°W

30°N30°N

25°N

15°N

25°N

20°N

15°N

110°W

110°W

105°W 100°W 95°W 90°W

105°W 100°W 95°W

85°W

MEXICO

This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other informationshown on this map do not imply, on the part of The World BankGroup, any judgment on the legal status of any territory, or anyendorsement or acceptance of such boundaries.

0 100 200

0 50 100 150 200 Miles

300 Kilometers IBRD 33447R

NO

VEM

BER 2008

MEXICOSELECTED CITIES AND TOWNS

STATE CAPITALS

NATIONAL CAPITAL

RIVERS

MAIN ROADS

RAILROADS

STATE BOUNDARIES

INTERNATIONAL BOUNDARIES