Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. P-4022-ME

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED LOAN

IN AN AMOUNT EQUIVALENT TO US$ 22.0 MILLION

TO

NACIONAL FINANCIERA, S.A.

WITH THE GUARANTEE OF

UNITED MEXICAN STATES

FOR A CHIAPAS RURAL ROADS PROJECT

March 29, 1985

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

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Currency Unit - Peso (Mex$)

On March 31, 1985, the exchange rate in the controlled market wasUS$1 = MexS208.79; the freemarket exchange rate stood at US$1 = Mex$226.85. Bothexchange rates are currently sliding at a rate of Mex$0.21 per day against the USdollar.

Fiscal Year

January 1 - December 31

Weights and Measures

Metric: British/US Equivalent

I meter (m) = 3.28 feet (ft)1 kilometer (km) = 0.62 mile (mi)1 kilogram (kg) = 2.20 pounds (lb)I metric ton (m ton) = 2,205 poundsI liter (1) = 0.26 gallons (gal)

AbbreviationsACF Average Cost of Funds

CECADE Economic Development Training Center (SPP)CONASUPO National Marketing Organization for Basic Foods

COPLADE State Development Planning Committees

COPLAMAR National Coordination Agency for Marginal Areas

CUD/CUC Federal/State Coordinating Agreements

EFF Extended Fund FacilityERR Economic Rate of ReturnICB International Competitive Bidding

IFAD International Fund for Agricultural DevelopmentLVA Value Added TaxJLC Local Roads CouncilLCB Local Competitive BiddingLIBOR London Inter-Bank Offer RateN de M Ferrocarriles Nacionales de Mexico,

(National Railways of Mexico)NAFINSA Nacional Financiera, S.A.NDP National Development PlanPEMEX Mexican Petroleum MonopolyPDR Regional Development ProgramPIDER Integrated Rural Development Program

PLANAT Rainfed Agriculture ProgramSAHOP Secretariat of Human Settlements and Public WorksSAP Special Action ProgramSARH Secretariat of Agriculture and Water ResourcesSCT Secretariat of Communications and TransportSED[. Secretariat of Urban Development and Ecology

SHCP Secretariat of Finance and Public CreditSPP Secretariat of Programing and Budgeting

FOR OFFICIAL USE ONLY

MEXICO

CHIAPAS RURAL ROADS PROJECT

LOAN AND PROJECT SUMMARY

Borrower: Nacional Financiera, S.A. (NAFINSA)

Guarantor: United Mexican States

Project Secretariat of Communications and Transport (SCT)ExecutingAgency:

Amount: US$22.0 million equivalent.

Terms: Repayment in 15 years, including three years of grace at thestandard variable interest rate.

Project The proposed loan is being presented simultaneously with anDescription: agriculture development project as part of the Bank's support

to the initial phase of the Government's development program

for the State of Chiapas. The Chiapas Development Plan is

designed to address the main constraints to the development ofthe State and to implement economic as well as social invest-ments. The areas of influence of the two proposed projectswould fit well into the priority areas of the Chiapas Develop-ment Plan.

The proposed project would support the initial stages of thisPlan through the execution of a rural roads construction,rehabilitation, improvement and maintenance program incoordination with other simultaneous social and economicdevelopment efforts. The project provides for:(i) construction of about 1,000 km of rural roads;

(ii) rehabilitation and improvement of about 2,000 km ofexisting rural roads; and (iii) consulting services andrelated technical support to carry out detailed engineeringand upgrade the administrative and implementation capabilitiesof the executing agency.

Beneficiaries: The intended beneficiaries of this project are State ruralresidents lacking adequate road access. The areas affectedwould be predominantly small farm communities for which agri-culture is the main source of income. A significant propor-tion of the beneficiaries are expected to be from the State'slarge, ethnically distinct indigenous population. The initialyear's program would serve about 40,000 people. The benefitswould be realized through increased agricultural production.In addition, local residents would benefit through improvedaccess to employment opportunities elsewhere in the state andbetter access to, and delivery of, social services.

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

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Risks: The project faces the following risks: The first one flowsfrom the fact that the institutional framework forcoordination of Federal and State level planning and implemen-tation activities under the Chiapas Program is new and largelyuntested in practice. This institutional risk may also haveimplications for the provision of adequate and timely counter-part funding. To address this problem, the Government istaking steps to improve the institutional and budgetarycapabilities of the executing agencies involved. In addition,there are two types of risks which could affect therealization of project benefits: (i) agricultural increasesmay not be realized because of delay in parallel actions suchas extension services, seeds and fertilizer provision andcredit; and (ii) road employment and construction targets maynot be met because of a possible shift to equipment-intensivemethods and/or budgetary limitations. By preparing theproject in close coordination with the parallel AgriculturalDevelopment Project and applying relatively conservativeassumptions to production potential, this risk expressed in(i) would be minimized. With regard to (ii), the programscope takes into consideration the local capacity for execu-tion and historic construction levels. Also, project prepara-tion has focused upon defining when labor-intensive methodsare most appropriate.

Estimated Costs: Local Foreign Total-- (USS millions)----

I. Investment ProgramRural Roads Construction 18.7 6.3 25.0Rural Roads Rehabilitation/Improvement 5.2 1.7 6.9Consulting services and technical

assistance 1.1 0.4 1.5

II. Project Base Cost 25.0 8.4 33.4III. Price Contingencies 6.2 2.1 8.3

IV. Total Project Cost 1/ 31.2 10.5 41.7

Financing PlanGovernment 19.7 - 19.7Bank 11.5 10.5 22.0

Total Project Cost 31.2 10.5 41.7

1/ net of taxes

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Estimated DisbursementsBank FY

1986 1987 1988 1989 1990 1991(USS millions)

Annual 2.0 3.9 5.1 4.8 3.8 2.4

Cumulative 2.0 5.9 11.0 15.8 19.6 22.0

Estimated All subprojects to be financed under the loan would beRate of appraised according to agreed technical, economic and socialIeturn: criteria and would, in general, have a minimum estimated rate

of return of 12%. Roads in less productive areas, servingsubstantial populations but not meeting the minimum economiccriteria applying traditional evaluation procedures, would be

reviewed on a social benefits basis. For such roads, themaximum cost per person served should not exceed US$450, andthe total cost should not exceed 15% of the rural roadsprogram. Rural road rehabilitation works would not requireeconomic evaluation, but selection of subprojects would bebased on a technical review of existing conditions, and the

confirmation of traffic and road utilization.

Staff AppraisalReport: Report No. 5494-ME, dated March 25, 1985

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

REPORT AND RECOMMENDATION OF THE PRESIDENTTO TRE EXECUTIVE DIRECTORS ON A

PROPOSED LOAN TO NACIONAL FINANCIERA, S.A.WITH THE GUARANTEE OF UNITED MEXICAN STATES

FOR A CHIAPAS RURAL ROADS PROJECTI/

1. I submit the following report and recommendation on a proposed loanto Nacional Financiera, S.A., (NAFINSA) with the Guarantee of United MexicanStates for the equivalent of US$22.0 million to help finance a Chiapas RuralRoads Project to be carried out by the Secretariat of Communications andTransport (SCT). This project is associated with a Chiapas AgriculturalDevelopment Project and together they represent the Bank's support for theinitial phase of the Chiapas Development Plan. The loan would be repaid over15 years, including 3 years of grace, at the standard variable interest rate.

PART I - THE ECONOMY

2. An economic report on Mexico (Mexico: Recent Economic Developmentsand Prospects, No. 4996-ME) was distributed to the Executive Directors on May14, 1984. The report's main conclusions and recent economic developments aresummarized below.

3. Following an import-substitution growth strategy, Mexico experiencedsome two decades of high and stable growth after the early 1950s. By the late1960s, however, Mexico had largely exhausted the "easy" and efficient possibil-ities for import substitution, and faced a choice between outward-orientedgrowth or continued inward-directed growth led by expansion of public sectorexpenditures and rising subsidies and protection of inefficient domesticproduction. By 1972 the choice was made to pursue the latter course. Publicsector expenditures as a percent of GDP more than doubled between 1970 and1982, from 18.8% to 42.5% (Report No. 4996-ME, p. 114). By 1976 Mexicoexperienced a serious financial and economic crisis, followed by an even moreserious one six years later. The discovery of large oil reserves in themid-1970s led Mexico to a quick economic recovery, but it also removed theurgency of policy reforms. Primary among these was the need to reduceprotection and the anti-export bias of the trade regime to thereby move overtime toward greater efficiency and international competitiveness. Oil revenuesalso temporarily helped finance the public sector deficit and reduced the needfor greater fiscal restraint.

1/ Parts I, II and III of this Report are identical to the correspondingsections of the President's Report for the Chiapas AgriculturalDevelopment Project (Report No. P-4023-ME) being distributed at thesame time as this report.

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Developments During 1977-1982

4. The stabilization measures initiated in 1977 and the discovery andexploitation of large oil resources in the mid-1970s allowed the Lopez PortilloAdministration (Jan. 1977 - Dec. 1982) to overeome the serious financial crisisof 1976 and to start working on structural, social and economic problems,including poverty, income and wealth inequality, unemployment, regionalimbalances and relatively slow agricultural growth. In the early years of thatAdministration (1978-80) GDP growth was high (8.5% a year), 2.5 million jobswere created, domestic consumption recovered, and the share of investment andsavings in GDP surpassed historical levels, but the economy became increasinglyoverheated.

5. Rapidly rising public expenditures unmatched by revenues led toincreasing public deficits. While inflation rose, no significant pressure wasfelt to adjust the exchange rate, thanks to the oil earnings and the relativeease of obtaining foreign finance. By mid-1981, the economic situation beganto mirror the scene prevailing before the 1976 financial crisis. The currentaccount deficit of the balance of payments reached 5.2% of GDP, while thedeteriorating international oil market conditions caused large revenueshortfalls with respect to budget expectations. The public sector deficit roseto just under 15% of GDP. Non-oil exports dropped, and the trade deficitreached record levels. External borrowing was used to finance part of thedomestic fiscal deficit and to defend the exchange rate. Mexico's foreign debtincreased rapidly, at a time of high and rising international interest rates.A stabilization program initiated by the Government in mid-1981 was notsufficient to redress the growing fiscal imbalance, the high cost of foreignloans and the increasing private capital flight fueled by the public's anxietyover Mexico's financial troubles.

6. The crisis came to a head in 1982. In February, as capital flightintensified, the Bank of Mexico had to stop supporting the peso, which thenexperienced a 40% devaluation in dollar terms. A large wage adjustment grantedin March 1982, which tended to undo the effects of the devaluation, andcontinuing slack in the oil market kept the balance of payments under strain.Under the circumstances, the international banking community became reluctantto commit new funds to Mexico, in the amounts required. These factors led to asecond devaluation of 35% in August 1982, while the acute shortage of foreignexchange forced the Government to suspend the amortization payments of most ofMexico's external public debt pending a broader agreement on its refinancing.Capital flight continued as private sector confidence was shaken by thenationalization of the banks in September 1982, and the mandatory conversion ofUS dollar deposits into pesos. Also put into effect were a generalized systemof exchange controls and quantitative trade restrictions covering anunprecedented 100% of imports.

Recent Developments

7. The Administration of President de la Madrid, that began its term inDecember 1982, lost no time in taking steps to recover domestic and external

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confidence, and stabilize the public sector and external finances. TheGovernment's stabilization program supported by an EFF agreement, approved bythe IMF in December 1982, laid the basis for restoring economic stability andfor the re-negotiation of that part of Mexico's public external debt on whichamortization payments had been discontinued in August 1982. Commercial banksagreed to restructure some US$19 billion of public sector debt and provide US$5

billion in net new loans for 1983. All obligations falling due between August23, 1982 and December 31, 1984 were restructured over an eight year period,starting from January 1983, with a grace period of four years and at aninterest rate of 1-7/8 percentage points over LIBOR (or 1-3/4 over the New Yorkprime rate). The US$5 billion syndication had a 6-year maturity, with a 3-yeargrace period, at a spread of 2-1/4 over LIBOR (2-1/8 over prime). Therestructuring exercise included an understanding that the international bankswould maintain their exposure to the Mexican banks that had been nationalized.At the same time, it provided a mechanism that would eliminate 1982 privatesector interest arrears and facilitate payment of the rescheduled principal onsuch debt.

8. A new two-tier exchange rate system was introduced, with a controlledmarket for imports, most proceeds from merchandise exports (except those ofin-bond industries) and debt related transactions, and a free market for allother transactions including those relating to tourism. The controlled ratewas originally set at Mex$95 = US$1, a depreciation of some 35% in relation tothe previously prevailing ordinary rate of Mex$70 per US dollar. It

depreciated at a rate of 13 centavos a day until December 1984, when the dailyslide was raised to 17 centavos. The free market rate had remained at aboutMex$150 per dollar until September 1983, when the authorities decided to let itslide as much as the controlled rate. The differential between the two rates,which in December 1982 stood close to 60%, is now down to less than 10%. Overthe past two years, the peso has gradually appreciated in real terms as

inflation in Mexico remained high. The Government increased the rate of slideof the peso from 13 centavos a day to 17 centavos in December 1984 and to 21centavos early March 1985, in order to bring it closer to the expectedinflation differential between Mexico and its trading partners. Domesticdeposit interest rates were also raised in early March 19B5 from an average of

about 45% to nearly 50%.

9. Under the IMF Agreement, the Administration committed itself to a

drastic reduction of the public sector deficit, from 18.0% of GDP in 1982 to

8.5% in 1983, 5.5% in 1984 and 3.5% in 1985. Substantial progress has beenmade during the past two years in meeting the program objectives although the

targets for 1984 were not fully met. The public finances were strengthened

considerably and the public sector deficit was reduced to 8.7% of GDP in 1983and an estimated 7.4% in 1984. The main reason for the higher budget deficitthan the 1984 target was the much higher than expected interest payments on the

domestic debt. Curbs on expenditures were wide ranging. However, recentestimates suggest that real public investment -- encompassing states and localgovernments -- may have been well in excess of the targets for 1984. Theauthorities have given priority to completing projects that were already far

advanced and to those that were important for employment, equity, or foreignexchange earnings. Nonetheless, public investment expenditures are estimatedto have declined to about 7% of GDP in 1983-84, well below the 1982 level of11.7%. The fiscal performance was also aided by significant price increasesfor nearly all public goods and services, including petroleum products,electricity rates, food, etc. The Government has committed itself to asubstantial reduction and eventual elimination of most subsidies, includingthose provided in the form of low interest rates.

10. The balance of payments experienced a major turnaround in 1983 withthe current account moving from a deficit of almost US$5 billion in 1982 to asurplus of US$5.5 billion. The strength of the current account and theavailability of external finance permitted Mexico to replenish itsinternational reserves while paying a large part of the arrears that hadaccumulated in 1982. The net use of foreign financing by the public sector wasUS$4.2 billion for the year--below the ceiling of US$5 billion under thestabilization program. The errors and omissions account of the balance ofpayments dropped from US$8 billion in 1982 to an estimated US$1.4 billion in1983, largely reflecting the decline in unrecorded capital outflows. The swingin the current account was mainly the result of a very sharp contraction ofmerchandise imports, to US$7.7 billion representing a decline of about US$7billion from their 1982 level. The recession, the large devaluation of thepeso and the quantitative restrictions all contributed to this. The balance ofpayments remained strong in 1984, with a current account surplus of US$3.7billion, and a further US$2.5 billion were added to the nation's foreignexchange reserves, which at the year's end are estimated at about 7J months ofimports. Although imports recovered considerably, a rapid rise in non-oilexports, particularly in the first quarter of 1984, ensured that the tradesurplus remained at the same level as in 1983, i.e., about US$13 billion.Growth in tourism and in-bond industry was also strong, and helped inalleviating unemployment. These favorable external trends during late 1983 andearly 1984 weakened in mid-1984, owing to an appreciating real exchange rate.

11. Fighting inflation remains the pivot of the Government's stabilizationprogram. Although the Government's own inflationary targets have been missedby wide margins, the rate of inflation continued to decline through mid-1984.It declined from a rate of about 100% in 1982 to 80% and 59% in 1983 and 1984.The main factors in this were restrained fiscal and monetary policies andmoderate wage adjustments. The flow of savings into the banking systemcontinued to rise, reflecting the beneficial influence of the exchange rate andinterest rate policies. The impact of the severe and sudden cuts in publicexpenditure and imports on economic growth in 1983 was serious when GDPdeclined by over 5%. However, the economic recovery in 1984 was stronger thanthe Government's expectations: GDP is estimated to have risen by about 3.5%compared to the earlier estimate of only 1%. Since the latter half of 1984,fiscal, monetary, and external trends have signaled a possible resurgence ofinflationary pressures.

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12. The Government also took steps to regain the confidence of bothdomestic and foreign private investors. These included efforts to deal withthe problems of private external debt, procedures to compensate owners ofnationalized banks, and a more flexible application of the foreign investmentlaw. Negotiations with commercial banks and other private creditors have beencompleted for the refinancing of nearly half of the total of US$11.6 billion ofprivate sector obligations at stretched out maturities varying between 6 and 12years, with 3- to 4-year grace periods. Moreover, the Goveinment undertook the

restructuring of Mexican private sector obligations guaranteed by official

credit agencies abroad. The Government has also transferred back to privateownership most of the 400 private firms that were controlled by the commercial

banks prior to their nationalization. These measures and announcements havebeen beneficial, but more remains to be done to restore confidence of Mexicanentrepreneurs and foreign investors. The Government realizes that this is anissue of the greatest importance as economic recovery beyond the currentstabilization period will depend critically on the resumption of vigorousprivate investment.

13. The general improvement in the Mexican economy has been widely noted,particularly by the international banking community. Mainly for this reason,the Government's 1984 borrowing of US$3.8 billion from commercial banks carriedmuch more favorable terms than the borrowing in 1983 (10 year maturity, 5-3/4year grace period, and a spread -if 1% over LIBOR or 1-1/8% over prime). Thenegotiations between the Goveriment and foreign commercial banks on therescheduling of foreign debt have been virtually completed. The draftagreement, covering close to US$50 billion, has been submitted by the Banks'Advisory Group (consisting of the 13 largest lenders) to some 500 smaller,regional banks for their acceptance. Under the proposed terms, the previouslynot-rescheduled debt (amounting to about $20 billion), which is due forrepayment in 1985-90, will have its maturities stretched over fourteen years.The maturities of the previously rescheduled debt coming due in 1987-90 will bestretched over eleven years. The 1983 syndicate loan of $5 billion will berestructured, after prepayment of $1 billion, to carry terms identical to the1984 syndicate loan. In summary, the pending rescheduling agreement willstretch maturities of US$50 billion public debt in such a way that the debtservice remains virtually constant between 1985-1998, in contrast to thepresent situation where 75% of the debt service is due in 1986-89. The bankswill have the choice of LIBOR, a domestic reference rate, or a fixed rate.These terms are based on the understanding that the Government will continue toadhere to prudent economic policies.2 /

Medium-term Prospects

14. The Government's strategy, as outlined in the National DevelopmentPlan (NDP) for 1983-88, combines special efforts to recover from the presentcrisis with a longeL-term perspective on regaining balanced and stable growth

2/ As of this writing, the rescheduling agreement was expected to be signedby end-March, following the agreement with the IMF on the third yearEFF, announced March 25, 1985.

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to overcome structural problems. The main problems facing Mexico in the yearsahead include the still very high rate of population growth (2.6% estimated for1983) together with an even higher rate of labor force growth (a little under4%), slow growth in agriculture, poverty, a highly skewed interpersonal andinterregional income distribution, and an overly oil-dependent economy with astrong anti-export bias.

15. The medium-term strategy presented in the NDP focuses on the need for

structural changes in the economy including a greater export orientationthrough revision of external trade policies, poverty alleviation through basicneeds policies and improvement in labor absorption, and decentralization ofeconomic activity. The basic elements of policies to address structuralproblems are mentioned in the NDP and further details on specific programs andschedules for policy adjustments are provided in the sectoral plans which were

prepared subsequently.

16. Mexico's medium-term prospects for recovery and stable economic growthare reasonably good, provided economic management continues to be prudent,private sector confidence is restored, and the international environmentremains favorable. Adequate domestic policies include inter alia continuedefforts to reduce the fiscal deficit, liberalize trade and minimize pricedistortions. Restoration of private sector confidence is crucial since only astrong and dynamic private sector will be able to raise investment from thepresent depressed levels and to supply the increasing non-oil export surplusrequired for the resumption of growth. As regards the external environment,the commercial banks are expected to maintain their exposure in Mexico in realterms, and foreign markets to be open to Mexico's non-oil exports. Mexico will

benefit directly from a continuing fall in interest rates in the world

financial markets (a one percentage point drop means a savings of about USS800million in overall interest payments which compares to a loss of $550 million

in gross export revenues that would result from a one dollar drop in the exportprice of oil).

17. Under reasonably favorable external and domestic conditions, Mexico'seconomic growth could reach a sustainable 6% a year--the post-War average forMexico --towards the late 1980s. This growth would materialize through asustained redirection of the economy toward a more outward-oriented growthpattern. Fiscal discipline, in the absence of improved domestic efficiency andexport development, is likely to entail a prolonged period of slow growth,characterized by insufficient labor absorption in internationally competitiveactivities, by domestic price distortions, and by continued need for subsidies.

External Debt and Creditworthiness

18. Mexico's external public debt increased by about US$4 billion during1983 and by about a similar amount in 1984. With an expected net new borrowingof some US$3 to US$4 billion a year, the ratio of external debt to GDP would

decline steadily from 41% in 1984 to 33% by 1990. The debt service ratio,after the proposed rescheduling, is projected to peak at 47% in 1988,thereafter it gradually declines to about 25% in 1995.

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19. At the end of 1983, the last year for which a comprehensive externaldebt report is available at this time, the Bank's share in Mexico's debt was4.3% (excluding undisbursed). The Bank share in Mexico's total public externaldebt service payments during that year was 4%. In view of the good medium andlong term potential of its economy and the prospect of continued pursuit ofsound economic policies by the present Administration, Mexico is consideredcreditworthy for IBRD borrowing.

PART II - BANK GROUP OPERATIONS IN MEXICO

Bank Operations

20. As of February 28, 1985, Mexico had received 85 loans from the Bankamounting to US$6,831.3 million, net of cancellations and terminations; ofthese, 58 loans totalling US$3,495.2 million were fully disbursed. The Bankheld US$5,488.8 million, of which US$2,031.7 million had not yet beendisbursed. Some 42% of Bank lending has been for agriculture and ruraldevelopment, 23% for industry, 11% for power, and 13% for transportation; theremaining 11% has been for water supply, tourism, urban development, vocationaltraining and pollution control projects. Annex II contains a summary statementof Bank loans as of February 28, 1985

21. Of the US$6.83 billion total lending, about US$3.5 billion was forestablishing or strengthening institutions for channelling credit to areaswhere credit supply was deficient or non-existent, and setting up in the com-mercial banking system the ability to carry out project-related appraisal ofinvestments in agriculture, industry and tourism. These credit programs havefacilitated lending to low-income farmers and small- and medium-scaleindustrial and tourism enterprises based on productive investment plans, ratherthan credit granted on the basis of collateral.

22. The Government arranged adequate budget financing in the years 1978to 1981, which significantly improved project implementation. Government andBank officials met periodically to review project implementation, and greaterattention was focused in Mexico on project monitoring. As a result of thesemeasures, most of the Bank-assisted projects were being implementedsatisfactorily until mid-1982 and disbursements rose from US$91 million in FY78to US$448 million in FY82. However, the present financial crisis is againcausing delays in the provision of counterpart funds, consequently, disburse-ments in FY83 declined to US$389 million. A Special Action Program (SAP) wasestablished in early 1983 to help the Government by alleviating the counterpartfunding constraints on development projects, and 18 Bank financed projects arereceiving support under the Program. Partly as a result of the SAP, disburse-ments during 1984 improved significantly at US$528.87 million or 35% overdisbursements in 1983.

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IFC Operations

23. As of February 28, 1985, IFC had made investment commitments in 27companies in Mexico, for a total of US$753.9 million, of which US$562.5 millionhad been sold, repaid or cancelled. A summary statement of IFC investments ispresented in Annex II. IFC has been working together with the Bank inpreparing proposals to establish a facility for provision of foreign exchangefinancing to private sector companies for the importation of machinery,equipment and spare parts required for production of exportable products, forefficient import substitution and for improvements in -he utilization of theirexisting productive capacity. IFC approved a US$100 million facility(including funds mobilized from foreign commercial banks) in 1983, which isproviding finance for fixed investments of a larger size than those assistedunder the Bank loan for an Export Development Project.

Bank Strategy

24. The main objectives of Bank lending in Mexico in the past eight yearshave been to: (a) support policies and programs leading to a wider distribu-tion of the benefits of economic growth; (b) help finance projects that, di-rectly or indirectly, contribute significantly to output and employment; (c)help reduce Mexico's urban-regional imbalances; and (d) help free bottleneckswhich prevent rapid growth. More recently, however, in response to Mexico'srequirements following the 1982 economic crisis, the Bank, in close cooperationwith the IMF, also supported the Government's stabilization program throughassistance for export promotion and intensified and broadened economic andsector work. As for medium term prospects, the volume and composition of Banklending to Mexico would be related to progress in the implementation of policyreforms needed for structural economic adjustments, through broad policyconditionality affecting the entire lending program or important parts of it.Specific policy reforms that are being pursued through a dialogue with theGovernment, to be conducted in parallel with the processing of lendingoperations, would cover priority macro-economic and cross-sectoral issues, suchas interest rate policy, energy pricing, subsidy reduction and exportdevelopment.

25. Because of the difficult structural problems of agriculture and thesector's crucial importance for the one-third of the nation's population livingin the rural areas, the Bank has made agriculture the leading sector for itslending. The Bank's agricultural lending program in Mexico has four goals:first, to help increase productivity of presently cultivated lands in general;second, to give emphasis to improving the productivity of small farmers; third,to complement infrastructure investments with support services, such asextension, marketing programs and credit; and fourth, to promote employment-generating investments in rural areas. The Bank has made 14 loans in FYs78-83totalling US$1,829.4 million for irrigation, rural development and agricul-tural, agro-industrial and livestock credit programs. A US$175 million loanfor a rural development project and a US$180 million loan for an irrigationrehabilitation project were approved by the Executive Directors in FY82, and a

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US$138.4 million loan for San Fernando rainfed agricultural development wasapproved in early FY83. A US$115 million loan for marketing perishables wasapproved by the Executive Directors in April 1983 and a $300 million EighthAgricultural Credit Project in June 1984. Projects for irrigationrehabilitation, extension and research (seed multiplication) and agriculturalcredit are in various stages of preparation.

26. Bank lending for industry has aimed at: (a) reduction of the balanceof payments deficit; (b) decentralizing industrial activities away from themajor, increasingly congested, urban areas; and (c) promoting greater employ-ment. A steel project which the Bank helped structure and finance is nowoperating in a previously underdeveloped area on the west coast of Mexico, andthe city in which it is located, Lazaro Cardenas, is developing into a newgrowth pole. Four loans for industrial projects to promote the development ofsmall- and medium-scale industrial enterprises, to finance expansion of small-and medium-scale mining, and to support an industrial equipment fund (FONEI)were approved by the Executive Directors in FY978-80. A US$90.0 million loanfor a vocational training project, which is assisting a program to increase thesupply of skilled workers and technicians, a US$152.3 million loan for thedevelopment of a capital goods industries project and a US$60 million loan forpollution control were approved by the Executive Directors in FY82. Amodification in the capital goods project was approved by the ExecutiveDirectors in early 1983 to set up a pilot export development fund to helpsatisfy the foreign exchange needs of Mexican exporters. A US$350 million loanfor an Export Development Project and a US$175 million loan for a ThirdSmall-and Medium-Scale Industry Development Project were approved by theExecutive Directors in FY83. Follow-up projects to support expansion of smalland medium scale mining enterprises and vocational training are underpreparation.

27. Bank lending for physical infrastructure has been focused on regionaldevelopment and strengthening of institutions and sector policies. Twohighway sector projects (FY79 and FY84), the fourth railway project (FY81) andan industrial ports project (FY84) support these goals. The first and secondmedium-size cities water supply and sewerage projects (FY76 and 81) reinforcethe planning, management and finance of specialized water supply and sewerageinstitutions at the federal and municipal levels, and contribute to theestablishment of tariffs more closely related to costs; a third project wasapproved by the Executive Directors on May 17, 1983. A fifth railway projectis under preparation.

28. The Government has adopted a National Urban Development Plan thatspells out its regional development priorities in operational terms. A projectto assist in the development of the Lazaro Cardenas urban area was approved bythe Executive Directors in FY78, and a second urban project for oil-producingsoutheastern Mexico was approved by the Executive Directors in FY81. A loanfor the preparation of a deconcentration program for the Mexico City Region wasapproved by the Executive Directors in August 1982. A low income housingproject is under preparation.

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29. The Economic Development Institute (EDI) is assisting CECADE(Centro de Capacitacion de Desarrollo Economico under the Secretariat ofProgramming and Budgeting) in training Government staff in projectpreparation, monitoring and evaluation. EDI assistance is directed atcourses on urban and regional development, agriculture, rural development and

agro-industries. The Bank has also assisted the Mexican authorities intraining personnel for managing water supply and industrial credit projects.

30. The Inter-American Development Bank (IDB) is the second largestsource of multilateral aid to Mexico. The IDB has made loans to Mexicototalling US$3.billion as of December 31, 1984. Over 50% of the total hasgone to agricultural and rural development projects, and the balance totransportation, industry, water supply and sewerage, tourism infrastructure,education, municipal development, and pre-investment. The IDB and the Bankhave coordinated their assistance on several projects. Each has made loansfor the national integrated rural development program (PIDER), agriculturaland livestock credit, small- and medium-scale industries development, andhotel development projects. The International Fund for AgriculturalDevelopment (IFAD) has approved a loan of US$22 million for a ruraldevelopment project in the state of Oaxaca which was appraised by the Bank'sstaff and for which the Bank is acting as c)operating institution foradministering the loan.

31. Bank-supported power, steel, fertilizer and tourism projects inMexico have been co-financed by several bilateral export credit agencies andcommercial banks. In January 1982, Mexico borrowed US$500 million from

commercial banks to provide complementary financing for Bank-assistedprojects where project specific co-financing would have been difficult.

PART III: THE CRIAPAS DEVELOPMENT PLAN

The Setting: Chiapas and the Southeastern Region of Mexico

32. The Southeast, which includes the States of Tabasco, Veracruz,Campeche, Quintana Roo, Oaxaca and Chiapas, is the least developed region ofMexico. Until the recent discovery and production of oil in Tabasco,Veracruz and Chiapas, this region grew at a lower rate than the rest of thecountry. Despite many natural resources, the Southeast suffers from socio-economic constraints which have hampered development efforts (serious infra-structure bottlenecks, shortage of skilled manpower and underdeveloped humanresources). The region also has the highest concentration of indigenouspopulation. Within the Southeast, Chiapas is perceived as a region of greateconomic potential, especially in agriculture, tourism and agroindustries.As a result, it has recently received priority attention from the Government.

33. Chiapas is the most rural 3tate in Mexico with a population of 2.3million, of which about 25% is indigenous. It is one of the poorest andleast developed States in the country, with a per capita annual income of

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about US$350, compared with the national average of US$2,250. However, it iswell endowed with natural resources which have not yet been fully exploitedor explored. About one third of the population is estimated to live in urbanareas which is about half the average national ratio. Agriculture representsabout 36% of the State's GNP, accounting for 80% of all employment. Ser-vices, commerce, construction and transport account for 31% of GNP andindustry, mining (petroleum) and hydro-electricity for the remaining 33%.

34. A poor intrastate communications system has kept factor mobilitylow, and thus contributed to sharp income and social disparities betweensubregions (the Coast, the Central Depression, the Central Highlands and theTropical Forest). There is a danger that plans for the accelerated develop-ment of Chiapas, if not properly conceived and managed, could exacerbatethese disparities because the most promising investment opportunities lie inthe relatively flat Coastal areas and Central Depression (irrigation anddrainage) where incomes are already higher and population densities lowerthan average. The least developed and relatively densely populated parts ofthe State are the less fertile and more fragile sloping areas in the CentralHighlands (the Altos) where communications are difficult. The Governmentaims at pursuing a more balanced growth pattern, with priority focus on treecrops, rainfed agriculture and transport in the Central Highlands. A majoreffort is being made to identify and prepare projects that will yieldsubstantial and sustainable income increases in those areas. Its initialstages are being supported through the studies component of the proposedChiapas Agricultural Development Project.

Regional Development Strategy

35. The Government requested Bank assistance in the formulation of astrategy for the development of Chiapas in September 1980. The followingyear, a multisectoral Bank mission visited the State and its report contrib-uted to the formulation of the Government's first initiative in regionaldevelopment policy and the Chiapas Development Plan, launched by the Presi-dent of Mexico in May 1983. In 1984, a similar plan was formulated for theneighboring State of Oaxaca. Other State development plans are underpreparation.

36. The new regional orientation in Mexico's approach to developmentplanning also required institutional changes to ensure the proper coordina-tion of Federal and State Government activities. As of 1981, DevelopmentPlanning Committees (COPLADES) were established in each State to plan,monitor and evaluate the activities of regional branches of central FederalGovernment, with the State Governor as chairman and the Regional Delegate ofthe Secretariat of Programming and Budgeting (SPP) as technical secretary.The central Government agencies are also represented on such Committees.These Committees formulate and propose annually to the Federal and StateGovernments the investment, expenditure and financing programs for the State,and oversee the execution of regional development plans. Furthermore, toformalize the coordination of development planning and project implementationat the State level, Coordinating Agreements are entered into between theFederal Government and each State (Convenios Unicos de Desarrollo, CUDs).Such an agreement between the Federal Government and the State of Chiapas was

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signed in February 1984. Within this framework, specific coordinatingagreements would be entered into for the implementation of the proposedparallel Agricultural and Rural Roads Projects (Section 3.02(a)(ii) of thedraft Guarantee Agreement).

37. Chiapas contains a number of unique ecological reserves which areimportant in terms of wildlife and plants, as well as for watershed manage-ment, soil conservation, water quality, fisheries and tourism potential.With Bank assistance, the Government has established an environmental reviewprocess applicable to all construction works, with the Secretariat for UrbanDevelopment and Ecology (SEDUE) acting as the responsible agency, to managethe impact of the proposed investments under the Chiapas Development Plan onthe delicate ecological balance and on the indigenous population in theState.

Program Objectives

38. To address the current uneven pattern of the State's development,and to help integrate the economically marginal regions into the developmentprocess, the Chiapas Development Plan aims at promoting greater social andeconomic equality between the various subregions and productivity improvementgenerally. These objectives would be achieved through a package of carefullybalanced and integrated plans for the development of physical and socialinfrastructure and directly productive activities, mainly in agriculture,supported by improvements and expansion in rural communications system. Thefirst stage of the Plan was initiated in 1983 and is expected to beimplemented over the remainder of this decade. Bank participation in thefinancing of this first stage includes the proposed priority Agricultural andRural Roads Projects, as well as measures to help monitor the program'simpact on the natural environment. The Government will finance basic infra-structure components and special assistance subprograms for the indigenouspopulation mainly concentrated in the Altos subregion. Under the proposedAgricultural Development Project, the Bank would support this objective byhelping finance soil conservation structures and related technical assist-ance, which are critical for the sustained development of this subregion.The second stage of the Chiapas Development Plan would focus in particular onthe promotion of agroindustries, fisheries, forestry and energy development.Future Bank participation would be dependent upon the identification ofsuitable investment opportunities through the studies component includedunder the proposed project.

39. Execution of the investments supported by the Bank would be theresponsibility of Federal sector agencies involved, the Secretariats ofAgriculture and Water Resources (SARH) and Communications and Transport(SCT). This would include physical planning, construction and supervision.Implementation of appropriate environmental protection measures would be theresponsibility of the Secretariat of Urban Development and Ecology (SEDUE).At the Federal level, a special multisectoral Directing Council for implemen-tation of the Chiapas Plan, composed of representatives of all the agenciesinvolved, would provide overall guidance. At the State level, COPLADE wouldcoordinate and monitor all project activities (para. 36). Counterpartfunding for the proposed agricultural and rural roads projects would come

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from the budgets of SARH and SCT and the Regional Development Program (PDR).

Agricultural credit would be financed outside the Chiapas Plan budget throughexisting credit programs in the State which are adequate to meet financingrequirements under the Plan.

Program risks

40. The Chiapas Plan is the first integrated regional developmentoperation in Mexico within a new and largely untested institutionalframework. Inevitably the new institutions are of uneven quality. TheFederal and local executing agencies within the CUD/COPLADE system (para. 36)would receive substantial inputs through the various projects to improvetheir institutional and budgetary capabilities. Despite those mitigatingmeasures, the execution of this complex multi-sectoral program entails acertain risk. However, the risk is considered inevitable and acceptable ifthe Bank is to support Mexico's renewed regional development efforts in a

substantive and timely manner.

PART IV - TRANSPORT SECTOR IN CHIAPAS 3/

A. Background

41. The transport system has been one of the most limiting factors of

the growth and integration of the specific subregions as well as of Chiapasas a whole, influenced by the State's particularly difficult topography andits relative distance from the more developed and populated coastal plateau

of Mexico. As a result, the sector not only lags in its role as catalyst fordevelopment, but also in servicing local demand.

42. The transport network of Chiapas consists mainly of about 8,600 km

of roads, including 2,840 km of paved roads, one Pacific Coast port, 540 kmof railway lines, and two major airports. The construction of the network isrelatively recent, with major highway connections having been completed inthe last five years. Most of the rural roads network of 4,000 km wasconstructed over the last ten years. The network is still sparse, as

evidenced by the fact that an estimated 500,000 people are without all-weather access.

43. Road transport is the principal transport mode for Chiapas. Thethree main axes are the Pan-American Highway, running from the Oaxaca stateborder to the Guatemalan border; the Pacific Coastal Highway, from Oaxaca to

Ciudad Hidalgo at the Guatemalan border; and the North Highway, runningnorth-south from the Tabasco state border to Ixtapa and Escopetazo on thePan-American Highway east of Tuxtla Gutierrez. While, until recently, most

3/ A discussion of the transport sector and related issues has beenpresented in recent FY84 President's Reports for Loans 2428-ME (Second

Highway Project) and 2450-ME (Industrial Port Project) approved inMay/June 1984 and no substantial changes have occurred. This report thus

focuses on the transport sector in Chiapas.

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of the rest of Mexico lacked only rural roads, Chiapas still faced theproblem of a limited trunk network. Rural roads funds were directed atfinishing the State's trunk network, resulting in many low-standard roadswith significant traffic volumes.

B. Investment priorities

44. Transport investment needs in the State are concentrated in theroad subsector and include: (1) completing the trunk network, to provide adirect connection between the main production areas of the Central Depressionand the Pacific Coastal highway; (ii) the upgrading of low-standard roadswith high traffic, especially in the Central Depression, with modernizationof existing federal trunk roads, and improved rehabilitation and maintenanceof existing rural roads; and (iii) the extension of the rural roads networkto potentially productive areas and outlying communities. These needs, withregard to the federal and state trunk network, are adequately treated inSCT's indicative 1984-1988 investment program, taking into account the over-all national budgetary restrictions. To help to determine future investmentpriorities for all modes, the Government agreed, at negotiations, to carryout a review of the transport investment priorities in the State and completea road master plan for Chiapas by December 31, 1986 (Section 3.06 of thedraft Guarantee Agreement).

C. The Rural Roads Sector

General

45. Prior to 1970, Mexico's road-building program was directed atdeveloping the Federal and State trunk network, while rural access waslargely ignored and only 12% of the total roads network (8,500 km of a totalof 71,500 km) were rural access roads. As a result, some 90,000 commu-

nities, 4/ representing 91% of the communities in Mexico, lacked all weatheraccess to the trunk network and the national economy. In 1970, ruraldevelopment was given greater priority, and new strategies were accordinglydevised with the objectives of better integrating the many small subsistence

farmers into the economy, stimulating economic growth in rural areas andproviding short-term employment. A key element in the rural developmentstrategy was the improvement of rural access, especially to areas withpopulation concentrations of over 350 people. Since 1970, the constructionof rural roads has been executed and financed by a variety of agencies. Theprincipal executing agency was the former Secretariat of Human Settlementsand Public Works (SAHOP), but SCT now carries out the program. In addition,SARH has constructed thousands of kilometers of roads, mainly farm serviceroads, as part of its investment programs.

4/ 82,000 communities with up to 500 inhabitants and 8,000 with over 500inhabitants.

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Rural Roads in Chiapas

46. Under the various construction programs, about 1,800 km of ruralroads were built in Chiapas between 1977 and 1983, excluding SARH roads. Theaverage annual rate of construction was about 250 km per year. The selectionof road projects has been largely ad hoc, and presently there is no consis-tent methodology for selecting roads and establishing priorities.

47. In Chiapas, the division of technical and financial respon-sibilities for selecting, designing, executing and maintaining the variousroads is complex and has developed as a result of the different road invest-ment programs which were started by federal, state and quasi-public enti-ties. This has led to the differing construction and maintenance policiesand capabilities of the various principal road-building agencies at thefederal, state and local levels which build roads relating to their majorinvestment projects. The Federal Government has taken action to consolidatethe various rural roads programs, so that SCT will have primary responsi-bility for construction and COPLADE for identification. Following the recentreorganization of transport sector responsibilities under SCT (1983), a more

favorable trend is developing since the investments focus more on upgradingand rehabilitation, and the network is being consolidated under SCT, includ-ing the rural roads program.

48. The state office of SCT has had long experience in the planning,design and construction of rural roads of the type and extent included inthis project, in administering associated construction contracts and in

carrying out such works through force account methods. However, while ruralroads constructed by SCT are designed to appropriate standards, there is alack of consistency between SCT and SARH rural road design standards. Theproject aims at promoting consistency in design, construction and mainte-nance standards. In order to promote this objective, the Governmentconfirmed, at negotiations, that, by December 31, 1987, it will carry out areview of the construction and maintenance practices regarding rural roads inthe State under the jurisdiction of SCT and SARH, with a view to furtherrationalizing rural roads designs, specifications, construction methods andmaintenance practices, and assignment of maintenance responsibilities betweenagencies to ensure effective maintenance (Section 3.08 of the draft GuaranteeAgreement).

49. With respect to maintenance practices, and due to the fact that,since 1971, the Government's attention has been directed toward the construc-tion of rural roads under different road investment programs, rural roadmaintenance is lacking in Chiapas as well as nationwide. To address thisproblem under the proposed project, the Government will review constructionand maintenance practices in Chiapas and develop a plan to allocatemaintenance responsibilities (para. 48). With over 80,000 km built in adecade, the requirements for maintenance, particularly periodic maintenance,spot improvements and rehabilitation have accumulated rapidly. The basicdeficiency is inadequate budgets. It is estimated that, in Chiapas, the

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average annual cost of appropriate routine and periodic maintenance is aboutUS$875 equivalent per kilometer, of which 50% represents periodic andemergency maintenance. Taking into account deferred needs, it is expectedthat average budgetary levels per km should be even higher. The Governmenthas recognized the problem and, for 1984, budgeted Mex$ 285 million (US$400per km equivalent) for SCT in Chiapas. On a national level, SCT hasprojected substantial real increases in its 1985-1988 investment program forrural road maintenance and rehabilitation, reaching about US$750 equivalentper km by 1988. During that period, the Government is also expected topermit more flexibility in the use of the rural roads construction budget inorder to meet deferred rehabilitation requirements. At negotiations, theGovernment confirmed that it will provide adequate resources to meet ruralroad maintenance requirements in Chiapas, including annual routinemaintenance of all rural roads within the SCT network. In addition,sufficient funds will be provided to carry out, under the SCT Rural RoadRehabilitation and Periodic Maintenance Program, an average of 350 km peryear in 1985 through 1987, gradually increasing to 500 km per year by 1988(Section 3.04(ii) of the draft Guarantee Agreement). This provision wouldrepresent an annual budget of US$700 per km equivalent by 1988. Asmaintenance budgets are increased, it will also be necessary to improve ruralroad inventory and project identification procedures. In Chiapas, theinitial coverage for the road inventory has been completed and the Governmentagreed at negotiations that it will update and furnish to the Bank byNovember 30, 1985, the inventory of rural roads in the State, and thereafterupdate the inventory on an annual basis (Section 3.04(i) of the draftGuarantee Agreement).

D. Rural Transport Services

50. Transport services in Chiapas are provided largely by the privatesector. The motorization rate is one of the lowest in Mexico. Institution-ally, the transport services sector appears strong and adequately organized.Regulatory solutions to problems on the State and Federal highway network aresought through a participatory planning process in which the various interestgroups involved are represented. However, little is known about the trans-port services provided on unimproved or recently improved rural roads, andhow these services may affect the way in which the benefits of road improve-ments are passed on to rural residents. To fill this gap, it was agreed atnegotiations that the Government would carry out a study of rural transportservices to be completed by December 31, 1986 (Section 3.07 of the draftGuarantee Agreement).

E. Past Bank Participation and Experience in the Transport Sector

51. The Bank has had an extensive involvement in the Mexican transportsector: (i) nine highway loans have been made, focusing upon the trunknetwork, the first in 1960 and the ninth (a Second Highway Sector Project -Loan 2428-ME) in 1984; (ii) four railway loans, with the Fourth RailwayProject (Loan 1929-ME) in execution; (iii) two port loans, including a portpreparation loan in 1981 (Loan 1964-ME) and the Lazaro Cardenas Industrial

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Ports Project (Loan 2450-ME) in 1984; (iv) an airport project (Loan 1022-ME),approved in 1974 and completed in 1982. In June 1982, the Bank issued a

completion report for the Seventh Highway Project, which concluded that,although the quality of works executed is satisfactory, cost increases,construction delays and insufficient budget allocations resulting from therecent economic crisis in Mexico have generally resulted in delayed

completion of Bank projects.

52. Rural roads construction has received Bank financing under agricul-tural projects, but not under transport projects. Most of such roads werebuilt by SARH and were farm service roads, not community access roads whichwere more typical of the main rural roads program. Bank agriculturalprojects have supported the PIDER program, which included community accessroads. The reviews of the PIDER projects identified transport issues thatcould best be handled under specific transport lending, particularly withregard to road selection criteria and maintenance budgets and practices.Thus, it was considered appropriate to prepare a rural roads project inparallel with an agricultural development project, to continue the integrateddevelopment framework of earlier projects, while allowing for a more focusedtreatment of important transport issues.

F. Bank Lending Strategy

53. The Bank's role in the transport sector has been expanded becauseof the measures taken by the Government on issues which have been of concernto the Bank during its long standing involvement in the sector, particularlywith regard to sector pricing and institutional reorganization. Further-more, a constructive dialogue on sector policies has been initiated betweenthe Bank and the Government which would be supported through the Bank's lend-ing and sector work program. The sector lending strategy, in accordance withthe Bank's overall objectives for lending to Mexico, is to develop relativelyquick disbursing loan operations which focus upon short-term investment in

maintenance, rehabilitation and modernization, and upon making prior invest-ments operational while assisting the Government, through the new PlanningDirectorate in SCT, in reassessing the medium- and long-term need for majornew investments.

54. The proposed Rural Roads Project has a more limited focus andrepresents, together with the proposed Agriculture Project for Chiapas, apilot effort to support comprehensive regional development. As with otherlending operations to the sector, this project attempts to achieve a betterbalance between new investment and maintenance and rehabilitation. It isexpected that the lessons of this project will serve as the basis for otherregional development plans being prepared, as well as for the national ruralroads program in general.

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PART V - THE PROJECT

Project Origin

55. The proposed project is part of the long-term development strategyfor the State of Chiapas (para. 38), first formulated with Bank assistance in1981 and subsequently embodied in the Government's Chiapas Development Plan(1983). Two priority elements were selected by the Bank as crucial to theinitial stages of the Program and which provided an appropriate instrumentfor Bank financing: agricultural development and rural roads. Therefore, twoprojects, the Chiapas Agricultural Development Project and the Chiapas Rural

Roads Project, have been prepared in parallel. This project was appraised inMarch 1984 and negotiated from February 25 through March 20, 1985 jointlywith the Agricultural Development Project (Report No. P-4023-ME dated March29, 1985. The Mexican Delegation was led by Mr. Luis Nava (NAFINSA) andincluded representatives from the Secretariats of Finance, Programming andBudgeting, Agriculture and Transport. A Staff Appraisal Report, entitled"Chiapas Rural Roads Project" (Report No. 5494-ME, dated March 25, 1985) isbeing distributed to the Executive Directors separately. Supplementaryproject data are included in Annex III.

Project Objectives and Composition:

56. The proposed Rural Roads Project would support the development ofChiapas through the implementation of a program for rural roads construction,rehabilitation, improvement and maintenance, coordinated with othersimultaneous social and economic development efforts under the Chiapas Plan.The project would provide for: (a) the construction of about 1,000 km ofrural roads; (b) the rehabilitation and improveaent of approximately 2,000 kmof existing rural roads; and (c) related consulting services and technicalassistance. The selected roads would provide the necessary integration ofthe State, reduce transport bottlenecks and costs between complementaryregions of the low lands coast, the central plateau and valleys of the Selva,while providing access to heretofore inaccessible areas of the State withgood development potential. Where appropriate, the project would promote theuse of labor-based construction techniques to offer increased employmentopportunities for unemployed and underemployed local residents.

57. To ensure the full realization of expected benefits, the RuralRoads Project is designed to support Government efforts to: (a) strengthenState planning and decision-making capabilities in Chiapas to a levelcommensurate with its increased responsibilities under the Chiapas Develop-ment Plan; (b) improve administration and implementation capabilities for theplanning, programing, construction, rehabilitation, improvement and mainte-nance programs for rural roads in Chiapas; (c) assess rural transportservices for freight and passengers in Chiapas; and (d) extend lessonslearned in Chiapas to other states.

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(i) Rural Roads Construction Component

58. The proposed project provides for the construction of 1,000 km ofrural roads over the project period, with an average construction program ofabout 200-250 km per year. This is based on the historical average of about250 km per year for Chiapas, and an appropriate overall mix of road invest-ments in Chiapas by SCT and other agencies. Within this program, prioritysubprojects were selected, based upon population density, construction costsand transport needs. An initial 269 km were confirmed for inclusion under

the project through economic or social evaluations to serve populationcenters of 100 to 6,100 people. Subprojects for subsequent years would be

selected on the basis of agreed upon procedures (paras. 69 and 73). Detailedengineering designs for the first 120 km of works comprising the first year'sconstruction program, and included for financing under this project, werereviewed in detail and were found to be satisfactory. Such designs would be

completed prior to Board presentation. A number of identified subprojects(52 k) have been postponed, pending an environmental review by SEDUE,because they are located in ecologically sensitive areas (para. 75).

(ii) Rural Roads Rehabilitation and Improvement Component

59. This component focuses on road segments which require priorityrehabilitation, improvement and/or periodic maintenance works. A fieldreview showed that the initial works identified (totalling about 300 kms)would vary in cost from US$3,000 to US$4,900 equivalent per km. Atnegotiations, the Government confirmed that the rural road inventory has beencompleted. The first year's construction program for rehabilitation andimprovement works will comprise about 250 km. The annual workload shouldthen increase gradually to about 500 km per year by 1988 with a total of 2000km during the project period (para. 49).

(iii) Consulting Services and Technical Assistance Component

60. The project includes consulting services for detailed engineeringfor rural road construction and technical assistance to SCT, includingdomestic and foreign consulting services, to support preparation of:(a) review of transport investment priorities in the State, includingpreparation of a road master plan for Chiapas; (b) study tours within Mexicoand abroad and provision of seminars at SCT headquarters in Mexico City onrural road planning, construction and maintenance; (c) carrying out ofappropriate pilot projects in Chiapas using non-standard technology andequipment in order to improve rural road construction and maintenancetechniques; and (d) preparation of revised manuals of rural road constructionand maintenance practices, as well as new manuals and guidelines, wherejustified. This program of work would be the responsibility of SCT, incoordination with COPLADE, mainly utilizing their own staff. However, sincethere is insufficient expertise and capabilities to carry out all the studiesplanned, the project provides for domestic and/or foreign consultingservices, which would be financed through the proposed loan. The terms ofreference of studies included under the project were agreed to duringnegotiations.

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Project Cost and Financing

61. The total cost of the project is estimated at US$41.7 millionequivalent, including price contingencies of about US$8.3 million equivalentand foreign exchange costs of about US$10.5 million. Price contingencies arecalculated at 5% for 1985, 7.5% for 1986, 8% for 1987-90 and 5% thereafter,based on Bank guidelines. Physical contingencies are not estimatedseparately because the costs are calculated on an average per kilometerbasis. The proposed Bank loan of US$22.0 million would be made to NAFINSA,with SCT as the executing agency. The Borrower would, through contractualarrangements on the same terms and conditions as those of the Bank loan,transfer loan funds to the Government for the carrying out of the Project(Section 3.01 of the draft Loan Agreement). SCT would act in coordinationwith COPLADE to carry out some technical components (para. 60). Theremaining funds required are expected to come from annual federal budgetaryallocations for SCT. The project would require about five years to execute,with a completion date of June 30, 1990. At negotiations, the FederalGovertment confirmed that sufficient counterpart funds as well as otherresources required for the purposes of the project in 1985 and thereafterwould be provided in a timely manner.

Procurement

62. All civil works included in the project would be executed by SCT.All procurement would be carried out in accordance with Bank policy, andfollowing procedures satisfactory to the Bank. In the case of rural roadsincluded in the project, the works are of two general types, construction andrehabilitation. Civil works for road construction would be grouped intocontract packages ranging in size from US$75,000 to US$700,000 equivalent inorder to realize economies of scale while, at the same time, providing arange of small to large sized contracts that could be executed by localcontracting firms. Contractors would be prequalified using SCT's standardprocedures which are acceptable to the Bank. The packages of constructionworks that would be carried out by contractors are relatively small in value,would employ light or minor quantities of equipment and are scatteredgeographically throughout the state. Foreign contractors, therefore, areunlikely to be interested in this type of work. Special efforts would

probably be necessary to interest domestic contractors from States somedistance from Chiapas. The rehabilitation works would be carried out, withrare exceptions, by SCT through force account. In some cases, small localcontractors would be used to execute minor works, to provide equipment or toact as labor contractors. For these reasons, civil works that would becontracted would be tendered using LCB. In carrying out the project'stechnical assistance components, SCT would employ consultants to the exLentneeded in accordance with Bank guidelines (Section 3.09 and Schedule 2 of thedraft Guarantee Agreement). With respect to the acquisition of the necessaryrights-of-way and rights-of-access for the first year construction program,during negotiations the Government confirmed that all necessary action hasbeen taken for this purpose.

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63. Local procurement procedures used in Mexico were reviewed in detailand were found to be generally satisfactory. During negotiations, agreementwas reached with the Government that certain procedures now followed would be

modified in order to agree more closely with the Bank's procurement guide-

lines and policies. In particular, additional time for prequalification ofcontractors and for bid advertisement and preparation will be allowed toincrease bidding opportunities and permit more careful bid preparation.

Disbursements and Special Account

64. Bank funds are expected to be disbursed over a six-year period.Based on this schedule, the closing date for the loan would be June 30,1991 (Section 2.03 of the draft Loan Agreement). Expenditures for civil

works included in the approved program and carried out under the project as

well as for the technical assistance components may be reimbursed from theSpecial Account (para. 65) on the basis of Statements of Expenditures.Disbursements would be on the basis of 50% of total net costs for civil works(rural road construction, rehabilitation and improvement) and 100% of totalexpenditures (excluding taxes) for both foreign and local currencyexpenditures for consulting services for detailed engineering and fortechnical assistance (Schedule 1 of the draft Loan Agreement).

65. To facilitate loan disbursements, NAFINSA, the Borrower, would setup a Special Account which would be operated in accordance with terms andconditions satisfactory to the Bank (Section 2.02(b) and Schedule 3 of thedraft Loan Agreement). Satisfactory auditing arrangements for the SpecialAccount were agreed during negotiations (Section 4.01 of the draft Loan

Agreement and Section 4.01 of the draft Guarantee Agreement).

Retroactive Financing

66. SCT is proceeding with the preparation and execution of the firstyear's construction program. Between July 1, 1984 and the anticipated dateof loan signature, approximately 80 km of new construction and 150 km ofrural road rehabilitation and improvement works are expected to becompleted. On this basis, the loan would include retroactive financing of upto USS2.2 million for expenditures in the approved program that are incurredafter July 1, 1984 but before the expected date of loan signature (Schedule

1, para. 2 (a) to the draft Loan Agreement).

Auditing

67. Appropriate auditing arrangements were agreed during negotiationsfor project accounts maintained by SCT to reflect the operations, resourcesand expenditures of the project (Section 4.01 of the draft Loan Agreement and

4.01 of the draft Guarantee Agreement).

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Project Administration and Execution

68. The proposed project would be implemented within the overall organ-izational framework established by the Government for the cc:rdination of theChiapas Development Program (paras. 36 and 39). SCT will be responsible forthe execution of the project, except for some technical components which itwould execute in cooperation with COPLADE (Section 3.01 of the draftCuarantee Agreement). During negotiations, the detailed implementationschedule, drawn on the baqis of Chiapas' overall construction program, wasreviewed and agreed upon.

Subproject Evaluation Procedures

69. In order to meet the need for a consistent methodology for roadselection and definition of priorities, COPLADE staff capabilities would bestrengthened through this project with the support of SCT, for theapplication of adequate subproject evaluation procedures. It was agreedduring negotiations that, on an annual basis during the project, SCT wouldprepare preliminary cost estimates for candidate subprojects and, then, SCTand COPLADE, with the assistance of SARH, would carry out the economic andsocial evaluation in accordance with agreed procedures. Road subprojectswith a minimum estimated economic rate of return of 12% would be consideredeligible, and summary data sheets would be submitted to the Bank for reviewand comments. Social criteria (para. 73) were also agreed upon atnegotiations in order to include a limited number of roads which servesignificant population groups in less productive areas (Section 3.03 of thedraft Guarantee Agreement). SCT would then prepare final engineering inaccordance with agreed upon design standards.

70. For rural road rehabilitation subprojects, it was agreed atnegotiations that, beginning November 30, 1985 and annually thereafter, SCTwould carry out a rural road inventory in the State in accordance with agreedupon procedures and would select priority rehabilitation and improvementworks from that survey (Section 3.04 of the draft Guarantee Agreement). Asummary program would be presented to the Bank annually for review andcomment and, after approval, financing would be provided for a portion ofthat program's budget.

Benefits and Justification

71. The problem of poor access to a large proportion of the State'srural population has been well documented, as have been the benefitsgenerated by previous rural road construction works in Chiapas. Because ofits comprehensive geographic coverage, the types of benefits to be generatedby the proposed project would vary in accordance with the specific needs ofthe communities to be served. For most of the subprojects, the benefits fromlower transport costs, more reliability, and better access to services, tech-nical assistance and farm inputs would be realized in the form of improveduse of existing cultivated lands, through reduced losses and higher yields,as measured by the incremental net value of additional production. Similar-ly, it is expected that, in many cases, the area of cultivated land would beexpanded. In addition, other benefits, more difficult to quantify, should be

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realized as outlying small communities, particularly indigenous communitieswith limited production potential, become better integrated with the mainroad network and receive better access to social services (e.g., educationand health services) as well as to job opportunities in other areas withgreater economic potential.

72. With a few exceptions, the road subprojects proposed for construc-tion in the first year lie outside the primary zone of influence of theChiapas Agricultural Development Project. The road network for the areasaffected by that project are either largely in place (needing rehabilitationin some instances) or would be provided as a byproduct of the drainagestructures to be built. Therefore, the zones of influence under the RuralRoads Project represent the next geographic areas for development, whereaccess must be provided before agricultural development benefits can berealized. A staged screening methodology has been applied for the selectionof the subprojects included in the first year program. The main economicbenefit is increased agricultural production which has been estimated basedon farm models relating to the associated Agricultural Development Project.The proposed new construction subprojects for the first year's program haveestimated rates of return generally in excess of 20%. Agreed upon procedureswill be applied in the following years of the project to select subsequenteligible works.

73. Although the principal criterion for accepting a road for financingunder the project is the effect upon production increases, it has beenapparent, through the preparation of the project, that there are areas ofChiapas with high population concentration but with limited agricultural orother natural resource potential. Particularly, in certain areas of theState, such as Los Altos, roads are planned as part of an effort to integrateremote and/or indigenous communities with the rest of the state and thecountry. Many of the benefits of these roads are difficult to calculate,such as access to health and educational services and to employment oppor-tunities outside the immediate zone of influence. The beneficial impact ofsuch roads has been documented in prior research conducted in Chiapas. Forinclusion in the Bank-financed program, it was agreed during negotiationsthat the total of such subprojects would not exceed 15% of the constructionprogram, and that each road would not exceed a construction coct of USS450per person served (Section 3.03 of the draft Guarantee Agreement). Thisindicator is based on assumptions regarding potential increases in communityearnings through outside employment, some increases in the value of localproduction, and the potential magnitude of other social benefits comparedwith the average cost of rural road construction. For an average 8 km road,the minimum population required would be 440 people with higher populationsrequired for higher cost or longer road sections. For the initial year'sprogram, two subprojects totaling 19 km are included based on a socialjustification.

74. The intended beneficiaries of this project are mostly small farmersand "ejidatarios"5/in the State of Chiapas who either lack adequate road

5/ "Ejidatarios," members of an "ejido," a form of group land tenure basedon usufruct.

- 24 -

access or whose road access has deteriorated. Typically, households in suchareas of Chiapas, for which agriculture is the main source of income, earnedabout US$750 per household, or US$135 per capita in 1980. A significantproportion of the beneficiaries are expected to be from the large, ethnicallydistinct indigenous population. With regard to the initial 31 subprojects(269 kn), the total affected population would be about 40,000 people.

Environmental Protection Measures

75. The impact of rural road improvements upon the physical environmentis minimized by the design standards and construction methods to be appliedunder the proposed project, which are based upon the principle of providingaccess to existing rural communities at minimum cost, while avoidingdisturbances to the natural terrain and excessive future road maintenancecosts. In order to provide for application of adequate protective measures,it was agreed at negotiations that a subproject would not be consideredeligible for financing under the project until SEDUE clearance has beenissued (Section 3.03(a) (iii) of the draft Guarantee Agreement).

Project Risks

76. The proposed project will be executed within the institutionalframework set up for the implementation of the Chiapas Development Plan(para. 68). Despite the noted commitment of the Government, the execution ofthe program would entail a certain degree of risk with implications for theavailability of adequate and timely counterpart funding. These risks wouldbe, however, considerably lower than those which would exist if no attemptswere made to control the ongoing uneven development of the State.Furthermore, the Government is committed to strengthen the institutional andbudgetary capabilities of the various agencies involved (para. 40).

77. The economic evaluation assumes an incremental change in farmproduction patterns as a result of road improvements. While this incrementhas been estimated conservatively, there is a risk that the expected yieldincreases and/or increases in area cultivated would not occur if technicalassistance, seeds and fertilizer, and credit fail to reach the majority offarmers. This risk would be minimized by the actions proposed under theextension component of the proposed parallel Chiapas Agricultural DevelopmentProject. This component is statewide in concept and is not limited to theagricultural subproject areas. COPLADE has the responsibility of ensuringthat these investments are included in the budgets of the respective agenciesand, through its monitoring and evaluation activities, determining thatneeded services are delivered in a timely fashion in the road-impact areas.

78. Additional benefits are derived from direct employment on theproject. There might be a risk that the project would fail to construct theplanned roads, or that the choice of technology might shift toward moreequipment-based methods during implementation, thus lessening employmentbenefits. The first risk would be minimized by the extensive preparatorywork done by SCT and COPLADE staff and the scope of the project, which takes

- 25 -

into consideration local capacity for execution and historic constructionlevels. The second risk would be minimized by the development of manuals fordetermining appropriate construction technology, i.e., equipment-based versuslabor-based methods.

79. Finally, benefits would accrue to the rural population, andespecially to the indigenous population which occupies unproductive land,through improved access to employment opportunities generated under theChiapas State Development Plan. The risks here are that new employmentopportunities may not arise, or that they may be taken by other people,particularly from neighboring Guatemala. To minimize the first risk, thisproject has been prepared in close coordination with the Bank-financedChiapas Agricultural Development Project, which is expected to generate theequivalent of 15,000 full-time jobs and to enhance agricultural productionthroughout the State.

PART VI - LEGAL INSTRUMENTS OF AUTHORITY

80. The draft Loan Agreement between the Bank and Nacional Financiera,S.A., the draft Guarantee Agreement between the United Mexican States and theBank, and the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement are being distributed to the ExecutiveDirectors separately. Special conditions of the project are listed inSection III of Annex III.

81. 1 am satisfied that the proposed loan would comply with theArticles of Agreement of the Bank.

PART VII - RECOMMENDATION

82. I recommend that the Executive Directors approve the proposedloan.

A. W. ClausenPresident

AttachmentsMarch 29, 1985

- 26 -ANNEX I

TAB LS 3A Page 1 of 5NXICO - SOCIAL INDICATORS DATA SHEXTMKICO mrmNE CROUPS (USIGNTID AVERAGUS) L

HOST (HOST RECENT ESTIMATE) bRECENT HIDDLE INCOME MIDDLE ICOK

1960z A 197A ESTIMAT T. AMERICA & CAR EUROPE

AREA (THODBAND Sq. MN)TOTAL 1972.5 1972.5 1972.5AGRICULTURAL 983.2 976.4 979.5

C m E CAPITA (US$) 360.0 730.0 2270.0 2106.6 2345.3

EAST CONSMPTION MR CAPITA(KILOGRAmS OF OIL EQUIVALENT) 539.0 773.0 1340.0 995.5 1122.8

POPULATIOU AMD wITAL STATISTICSPOPULATION.NID-TEAR (THOUSMIDS) 37073.0 51176.0 73122.0MUAN POPULATION (I OF TOTAL) 50.8 59.0 68.0 66.5 46.6

POPULATION PROJECTIUMSPOPUIATION IN YEAK 2000 (HILL) 109.4STATIONARY POPULATION (MILL) -198.5 .POPULATION IOMENTUM 1.9

POPULATION DENSITYPER Sq. KM. 18.8 25.9 36.1 35.7 82.9PER SQ. ot. AcRE. LAND 37.7 52.4 72.5 92.4 158.9

POPULATION AGE STRUCTURE (2)0-14 TUS 45.6 46.5 44.3 39.9 31.6

15-64 TRS 51.0 50.0 52.2 56.0 61.165 AND ABOVE 3.4 3.5 3.4 4.1 7.1

POPULATION CROWTH RATE (Z)TOTAL 3.0 3.2 3.0 2.4 1.6URBAN 4.8 4.7 4.2 3.6 3.7

CRUDE BIRTH RATE (PER THOUS) 45.4 43.4 33.9 31.3 23.4CRUDE DEATH RATE (PER THOUS) 12.2 9.7 7.1 6.1 B.8GROSS REPRODUCTION RATE 3.3 3.2 2.2 2.0 1.6

FAMILY PLANNINGACCEPTORS. ANNUAL (THOUS) .. 25.1 1145.0 IcUSERS (I OF MARRIED WMEN) .. .. 39.07; 40.3

F003 A MIURITIONINDEX OF FOOD PROD. PER CAPITA(1969-71-100) 97.0 100.0 104.0 114.3 114.5

PER CAPITA SUPPLY OFCALORIES (2 OF REQUIREMENTS) 117.0 112.0 12L.0 110.6 128.6PROTEINS (CAMS PER DAY) 69.0 66.0 74.0 67.3 89.7

OF IKICR ANIMAL AND PULSE 29.0 27.0 28.0 /d 34.1 34.5

CHILD (AGES 1-4) DEATH RATE 10.3 6.5 4.0 5.7 5.2

HEALTHLIFE EXPECT. AT BIRTH (YEARS) 57.0 6L.3 65.4 64.7 67.4-INFANT DRT. RATE (PER THOUS) 91.1 73.6 52.9 60.6 54.2

ACCESS TU SAFE WATER (ZPOP)TOTAL 23.5 49.0 Ie 58.0 le 65.4URBAN .. 68.5 /e 51.4 / 78.1RURAL .. 21.0 51.07 46.2

ACCESS TO EXCRETA DISPOSAL(Z OF POPULATIUN)

TOTAL .. 37.0 le 38.0 le 52.9URBAN .. 60.0- 50.1 IW 67.0RURAL .. . 13.o 7 24.5

POPULATION PER PHYSICIAN 1830.0 1510.0 .. 1917.7 1065.6POP. PER NURSING PERSON 3650.0 1390.0 .. 815.8 764.4POP. PER HOSPITAL BED

TUrAL 590.0 970.0 .. 367.2 326.3URBAN 570.0 It 1170.0 .. 411.5 201.5RURAL .. 1370.0 .. 2636.3

ADMISSIONS PER ROSPITAL BED .. .. .. 27.3 20.0

HOUSINcAVERAGE SIZE OF HOUSEHOLD

TOTAL 5.4 5.7URBAN 5.7 5.7RURAL 5.2 5.8

AVERAGE NO. OF PERSONS/ROOMTOTAL 2.9 2.5URBAN 2.6 2.2RURAL 3.4 3.2 .

ACCESS TO ELECT. (2 OF MWELLINGS)TOTAL .. 58.9URBAN .. 80.7RURAL .. 27.8

- 27 -ANNEX I

TABLE 3 Page 2 of 5

MEXICOO- SOCIAL INDICATORS DATA SHEETMEXICO REFERENCE GROUPS (WEIGHTED AVERAGES) L4

MOST (HOST RECENT ESTIMATE) /bRECENT MIDDLE INCOME MIDDLE INCOME

196 197L ESTINATFLI. LAT. AMERICA & CAR EUROPE

anucanogADJUSTED ENROLLMENT RATIOS

PRIMARYs TOTAL 80.0 104.0 121.0 105.4 101.1MALE 82.0 106.0 122.0 106.3 105.5FEHALE 77.0 102.0 120.0 104.5 96.7

SECONDARYr TOTAL 11.0 22.0 51.0 43.2 59.1HALE 14.0 26.0 54.0 42.3 6d.9FEMALE 8.0 17.0 49.0 44.5 50.6

VOCATIONAL (2 OF SECONDARY) 23.6 26.7 11.6 33.6 2L.6

PUPIL-TEACHER RATIOPRIMARY 44.0 46.0 37.0 30.1 25.1SECONDARY 13.0 14.0 18.0 16.8 20.5

ADULT LITERACY RATE (2) 65.4 74.2 82.7 79.5 75.6

CONSIMPrlMPASSENGER CARSITHOUSAND POP 12.9 24.1 61.3 46.0 54.7RADIO RECEIVERS/THOUSAND POP 89.0 273.7 295.4 225.6 164.9TV RECEIVERS/THOUSAND POP 17.5 58.5 108.1 107.2 123.8NEWSPAPER ("DAILY GENERAL

INTEREST") CIRCULATIONPER THOUSAND POPULATION 73.3 .. 64.5 /a 63.5 96.3

CINEMA ANNUAL ATTENDANCE/CAPITA 9.8 4.9 4.4 /c 2.8 2.9

IAllR FORCETOTAL LABOR FORCE (THOUS) 11191.0 14722.0 21398.0

FEMALE (PERCENT) 15.2 17.4 20.0 23.2 34.5AGRICULTURE (PERCENT) 55.1 45.2 35.6 31.5 40.7INDUSTRY (PERCENT) 19.5 22.9 25.8 23.9 23.3

PARTICIPATION RATE (PERCENT)TOTAL 30.2 28.6 29.3 32.2 42.9KALE 51.1 47.4 46.7 49.3 54.7FEMALE 9.2 10.1 11.7 15.2 31.0

ECONOMIC DEPENDENCY RATIO 1.6 1.7 1.6 1.4 0.9

INCOME DISERUTIONPERCENT OF PRIVATE INCOERECEIVED BY

HIGHEST 5% OF HOUSEHOLDS ..HIGHEST 202 OF HOUSEHOLDS 61.1 lb 60.7 57.7 /ILOtEST 20% OF HOUSEHOLDS 3.47- 3.3 2.9 7d.LOWEST 402 OF HOUSEHOLDS 9.8 Wh 9.9 9.9 7d*

POVERTY TARGBT GROUPSESTIMATED ABSOLUTE POVERTY INCOMELEVEL (USS PER CAPITA)

URBAN .. .. .. 288.2RURAL .. .. .. 184.0

ESTIMATED REIATIVE POVERTY INCOMELEVEL (USS PER CAPITA)

URBAN .. .. 471.0 /c 522.8RURAL .. .. 67L.0 372.4

ESTIMATED POP. BELOW ABSOLUTEPOVERTY INCOME LEVEL (2)

URBAN ..RURAL ..

NOT AVAILABLENOT APPLICABLE

NOTES

Ia The group averages for each indicator are population-weighted arithmetic means. Coverage of countries among theindicators depends on aveilability of data and is not uniform.

l Unless otherwise noted, "Data for 1960" refer to any year between 1959 and 1961; "Data for 1970" between 1969 and1971; and data for "Most Recent Estimate