Document of

The World Bank

Report No: 21842-ME

PROJECT APPRAISAL DOCUMENT

ON A

PROPOSED LOAN

IN THE AMOUNT OF US$5.0 MILLION(EQUIVALENT)

TO

NACIONAL FINANCIERA, S.N.C.

WITH A GUARANTEE OF

THE UNITED MEXICAN STATES

FOR A

SOUTHEAST REGIONAL DEVELOPMENT LEARNING AND INNOVATION PROJECT

September 26, 2001

Finance, Private Sector and Infrastructure Sector Management Unit (LCSFP)Colombia, Mexico and Venezuela Country Management Unit (LCC1C)Latin America and the Caribbean Region (LCR)

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CURRENCY EQUIVALENTS

(Exchange Rate Effective 6/20/01)

Currency Unit = Mexican PesosI Pesos = US$0.104

US$1 = 9.6

FISCAL YEARJanuary 1 -- December 31

ABBREVIATIONS AND ACRONYMS

APIS Beekeepers Association of Yucatan (Agr6asociaci6n de Apicultores S.A.)BANCOMER Commercial Trade Bank (Banco de Comercio)BANCOMEXT Foreign Trade Bank (Banco de Comercio Exterior)BDS Business Development ServicesCANACINTRA Chamber of Industrial Transformation (Camara de la Industria de laCAS Country Assistance Strategy Transformaci6n)CGAP Consultative Group to Assist the PoorestCONACYT National Council of Science and Technology (Consejo Nacional de Ciencia y Tecnologia)EIU Economist Intelligence UnitEU European UnionFMA Financial Management AssessmentGDP Gross Domestic ProductICT Information Communications TechnologyINEGI National Institute of Statistics, Geography and Informatics (instituto Nacional de Estadistica,

Geografla e Informatica)INI Instituto Nacional IndigenistaISA International Standards on AuditingISP Internet Service ProvidersMFI Microfinance InstitutionMSB Micro and Small BusinessNAFIN Nacional Financiera S.N.C.NAFTA North American Free Trade AgreementNGO Non-Governmental OrganizationPCU Project Coordination UnitPMR Project Management ReportPROBECAT Training Program for Unemployed Labor Force (Programa de Capacitaci6n para Desempleados)SECODAM Ministry of Procurement (Secretaria de Contraloria y Desarrollo Administrativo)SECOFI Trade and Industrial Promotion Secretary (Secretaria de Comercio)SHCP Ministry of Finance (Secretaria de Hacienda y Credito Publico)TA Technical AssistanceTIIE Interbank Lending Rate (Tasa de interds interbancaria de equilibrio)UFE Special Financing Unit of NAFIN (Unidad de Financiamientos Especiales)

Vice President: David de FerrantiCountry Manager/Director: Olivier Lafourcade

Sector Manager/Director: Danny LeipzigerTask Team Leader/Task Manager: Mike Goldberg

MEXICOSOUTHEAST REGIONAL DEVELOPMENT LEARNING AND INNOVATION PROJECT

CONTENTS

A. Project Development Objective Page

1. Project development objective 22. Key performance indicators 2

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 22. Main sector issues and Government strategy 33. Learning and development issues to be addressed by the project 74. Learning and innovation expectations 8

C. Project Description Summary

1. Project components 102. Institutional and implementation arrangements 103. Monitoring and evaluation arrangements 19

D. Project Rationale(This section is not to be completed in a LIL PAD)

E. Summary Project Analysis

1. Economic 212. Financial 213. Technical 224. Institutional 225. Environmental 266. Social 267. Safeguard Policies 29

F. Sustainability and Risks

1. Sustainability 302. Critical risks 303. Possible controversial aspects 31

G. Main Conditions

1. Effectiveness Condition 31

2. Other 32

H. Readiness for Implementation 32

I. Compliance with Bank Policies 33

Annexes

Annex 1: Project Design Summary 34Annex 2: Detailed Project Description 37Annex 3: Estimated Project Costs 57Annex 4: Cost Benefit Analysis Summary, or Cost-Effectiveness Analysis Summary 58Annex 5: Financial Summary for Revenue-Earning Project Entities, or Financial Summary 59Annex 6: Procurement and Disbursement Arrangements 60Annex 7: Project Processing Schedule 68Annex 8: Documents in the Project File 69Annex 9: Statement of Loans and Credits 70Annex 10: Country at a Glance 73

MAP(S)Map No. 31292

MEXICOSoutheast Regional Development Learning and Innovation Project

Project Appraisal DocumentLatin America and Caribbean Region

LCSFR

Date: September 26, 2001 Team Leader: Michael J. GoldbergCountry Manager/Director: Olivier Lafourcade Sector Manager/Director: Danny M. LeipzigerProject ID: P060577 Sector(s): DS - Small Scale EnterpriseLending Instrument: Learning and Innovation Loan (LIL) Theme(s): Private Sector

Poverty Targeted Intervention: N

Program Financing Data[X] Loan [ 1 Credit [ ]Grant [1 Guarantee [ J Other:

For Loans/Credits/Others:Amount (US$m): 5.0 (including front-end fee)

Proposed Terms (IBRD): Fixed-Spread Loan (FSL)Years to maturity: 10

Commitment fee: 0.75%Financing Plan (US$m): Source Local Foreign TotalBORROWER 2.95 0.10 3.05IBRD 4.50 0.50 5.00LOCAL GOVTS. (PROV., DISTRICT, CITY) OF BORROWING 1.11 0.00 1.11COUNTRYLOCAL SOURCES OF BORROWING COUNTRY 1.44 0.00 1.44Total: 10.00 0.60 10.60Borrower: NAFINResponsible agency: NAFINNacional Financiera (NAFIN), S.N.C.Address: Insurgentes Sur, 1971, Mexico D.F.Contact Person: Roberto Casillas, DirectorTel: 52-5-325-6000 Fax: 52-5-325-7097 Email: rcasillas@nafm.gob.mx

Estimated disbursements ( Bank FYIUS$m):FY 2002 2003 2004 2005

Annual 1.93 1.38 1.21 0.48

Cumulative 1.93 3.31 4.52 5.00

Project implementation period: 2001-2005Expected effectiveness date: 12/05/2001 Expected closing date: 12/31/2005

OCS PAD 0020 Rev M0 20:h,

A. Project Development Objective

1. Project development objective: (see Annex 1)

The objective of the Project is to assist the Borrower, the Participating States and the private sectoroperating in such States to learn about: (a) the requirements for the development and implementation ofsustainable microfinance methodologies to promote access to financial services to unserved populations;and (b) the use of information communications technology (ICT) to deliver business development services(BDS) to microbusinesses in a cost effective and sustainable manner.

2. Key performance indicators: (see Annex 1)

The key indicator of overall project success will be the demonstration of the requirements (in termsof management systems, products and services, governance structures and other features) to establishsustainable microfinance institutions (MFIs) and infocenters providing business development services tounserved populations.

The learning indicator of the Microfinance Services Component is the demonstration ofmicrofinance management systems, governance structures, promotion and product mix that can lead tosustainability and outreach to the poor, under the evolving legal and regulatory framework. Thesustainability and outreach of the Eligible Microfinance Institutions (MFIs) will be measured by: (i) theefficiency, adjusted profitability, and portfolio quality of each eligible MFI; (ii) the adoption of newfinancial management systems, the development of new products, and policies on credit administration andinterest rates; and (iii) increases in the number of active clients. In addition, the component will documentthe effects of recent changes in financial sector regulations for non-bank financial institutions on MFIs.

The learning indicator of the ICT-based Business Development Services Component is thedemonstration of the services and systems (hardware, software, local content and business tools) requiredfor an Eligible Infocenter to reach the breakeven point. This will be measured by: (i) demand for services(number of people using the infocenter per week, type of services demanded, and applications used viaInternet); (ii) service performance (client satisfaction with each service provided); (iii) financialsustainability (operating and net income); (iv) the development of new applications that could improveaccessibility, affordability, effectiveness; and (v) the efficiency of business development services provisionthrough ICT.

The Institutional Development and Capacity Building Component develops the monitoring andsupervision capacity of the Project Coordination Unit (PCU), enabling the Nacional Financiera (NAFIN) tothoroughly document the requirements for working efficiently with and providing useful services to MFIsand ICT-based BDS providers (also known as infocenters) in Participating Southeastern States. Thelearning indicator is the ability of NAFIN to adapt its standard products and management systems to theMFIs and infocenters, which represent new clients for NAFIN.

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1)Document number: R2001-0089 Date of latest CAS progress report discussion: 6/21/01

The joint IBRD/IFC Mexico Country Assistance Strategy (CAS), in which this Project isspecifically mentioned, was discussed by the Board of Directors on June 8, 1999 (R99-92). The CAS hasthree strategic objectives: (i) removing obstacles to sustainable growth and maintaining macroeconomicstability in the context of globalization; (ii) social improvement (poverty reduction, education, basic health

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care, and rural development in marginal areas); and (iii) enhancing public governance (including thepromotion of decentralization).

The objective of this Project will contribute to these three CAS objectives. The Project willsupport the CAS objective of removing obstacles to sustainable growth by promoting private sector-ledstrategies to the development of microfinance institutions and microbusinesses, while building strongpartnerships with state governments, local chambers of commerce and business associations, and NAFIN.The majority of MFIs in the Participating Southeastern States are private sector institutions (with thenotable exception of the Buenaventura Program in Campeche). The methodology used to developinfocenters will also promote public-private partnerships and a commercial approach to ICT-based BDSprovision, involving business associations and chambers.

Fostering private sector development in less-developed regions is one of the strategies under theCAS. The Project will help to remove impediments to broad based private sector growth and will enhancecompetitiveness of local firms in the Participating States. This change is crucial for some of theSoutheastern States such as Campeche, Quintana Roo and Yucatan, which historically have basedeconomic development on enclave economies (petroleum in Campeche, henequen plantations in Yucatan,and tourism in Quintana Roo).

The CAS calls for activities that promote significant poverty alleviation. The CAS notes thattwo-thirds of the rural population in Southern States is considered poor, compared to one third nationwide.This persistent poverty has been linked to a lack of access to markets and productive assets, includingmarket information, capital and technology. The choice of the Project's target client population (urban andrural clients) will also increase the poverty alleviation contribution of this Project. Experiences from awide range of microfinance institutions in Latin America and other regions clearly demonstrate thatmicrofinance methodologies and microbusiness development support can make an important contribution topoverty alleviation (for example, village banking programs and solidarity group programs have averageloan sizes ranging from $75 to $200 in the region). These methodologies are employed by the MFIs that aremost likely to become eligible for Project financial and technical assistance services. The infocenters canplay a key role in poverty alleviation by linking small and microbusinesses to more profitable markets. Thisallows small and microbusinesses to move beyond subsistence level production, create new jobs, andimprove local income and investment.

2. Main sector issues and Government strategy:

Private Sector Structural Problems

The liberalization of trade and investment that began in the mid-1980s and Mexico's entry into theNorth American Free Trade Agreement (NAFTA) in 1994 were intended to achieve higher rates ofeconomic growth by expanding the country's participation in dynamic external markets and facilitatingaccess to high-quality inputs and technologies. Since the Peso Crisis of 1995, when the GDP contracted by6.2%, the national economy has enjoyed a strong recovery in overall terms (averaging 5.4% annually).This growth has contributed to an annual expansion in employment of 4.0% over the past four years,compared to an annual increase of 3.9% of the economically active population (INEGI, 2000). The rapidgrowth of the maquiladoras has fueled higher employment in urban areas, while agriculture has continuedto drop as a source of work in rural areas.

Despite the wide-ranging economic reforms instituted in the country, the income distribution inMexico remains among the most unequal in the world. Constraints to more balanced economicdevelopment include uneven regional development, tight credit markets, and little access to existingbusiness development service programs by micro and small businesses.

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Uneven regional development. The country faces huge differences in the level of industrializationand in the decline of agriculture that have sharpened the divisions that exist between different regions. Thecentral region, which includes the Federal District and the State of Mexico, accounts for nearly one-third ofGDP despite the fact that it covers only 1.2% of the land area. Monterrey (Nuevo Le6n) and Guadalajara(Jalisco) are the leading industrial cities after the capital. The maquiladora industry in the border area hasboosted employment. Tijuana in Baja California and Ciudad Juarez in Chihuahua have become importantmaquiladora cities. The Southeastern States still face widespread poverty problems, due in part toinadequate transport and communications infrastructure, a history of enclave development, and a lack ofinvestment.

This pattern of unequal regional development translates into increased poverty in many parts of thecountry. Mexico continues to have one of the highest Gini coefficients in the region, with the lowest decileof the population controlling 1.5% of national income, and the top 10% in control of 42.8% of nationalincome. Gini coefficients measure income distribution disparity, comparing deciles of the population interms of their control of national wealth. Poverty indicators have been deteriorating in recent years.According to a survey in 2000, about 62% of the economically active population earns less than 2 times theminimum wages per day (the national poverty level, equivalent to US$7 per day). INEGI estimates that theminimum wage in real terms dropped 40.7% between 1994 and 1999. The number of people living belowthe poverty line in the 38 largest cities increased from 29 million to 38 million from 1994 to 1998. Thevast majority of informal sector producers and traders in the Project area are living under the nationalpoverty line.

Recent surveys in three Southeastern States reveal the importance of microbusinesses. The Statesof Campeche, Quintana Roo and Yucatan are characterized by large numbers of microbusinesses, whichface a general lack of access to affordable, reliable, appropriately designed financial services and timelymarket information. In the 1992 National Census, INEGI defined microbusinesses as those with one to tenworkers, including the owner. Based on the universe of 5,212 formally registered businesses in Campeche,the municipalities of Campeche and Ciudad del Carmen concentrated 88% of all the firms in the state. InYucatin and Quintana Roo the firm-size distribution is also concentrated at the microbusiness level (97%of all firms). (The inclusion of unregistered firms would increase the share of microbusinesses in thesample even more.)

Private Sector Firm-Size Distribution: 1993-1998 (all sectors, INEGI surveys)

1993 Micro Small Medium Large Total

Campeche 18,148 274 24 0 18,446

Yucatan 55,497 1,025 105 28 56,655

Quintana Roo 19,128 562 54 28 19,772

Total 92,773 1,861 183 56 94,873

1998 Micro Small Medium Large Total

Campeche 19,518 364 29 8 19,919

Yucatan 55,391 1,142 141 43 56,717

Quintana Roo 26,108 782 97 30 27,017

Total 101,017 2,288 267 81 103,653

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Tight credit markets. Despite an easing in nominal interest rates, credit markets have becometight. Small and medium sized firms with traditional collateral to back loans are not able to obtain credit,given the banks' reluctance to increase exposure to such firms. A survey by the Banco de Mexico, (thecentral bank) shows that only 33% of 500 companies surveyed had received bank credit in the third quarterended September 30, 2000. This is well below the 39% that received financing in the third quarter of 1999.On an inflation-adjusted basis, interest rates for the best clients are now nearly 10% in real terms.

Recent surveys have identified access to financial services as a key constraint to small andmicrobusiness growth. Survey by Desarrollo Empresarial de Campeche, 1999 and Market DemandSurvey in Campeche, 2000. For the private sector as a whole, the credit decline has continueduninterrupted since the end of 1994. For all firms, the total amnount of loans at the end of March 2000 wasstill 42% below the end of 1994 level, in real terms. For small and microbusinesses, the situation is evenmore bleak. Small and microbusinesses have not qualified traditionally for bank loans, and have turned todevelopment banks, particularly NAFIN, through arrangements with first-tier commercial banks. Duringthe Peso Crisis of 1995, and the subsequent recovery in 1996-97, the volume of credit declined significantlyfrom earlier levels. Development banks tried to compensate for the lack of credit that could be channeledthrough commercial banks by providing loans directly. However, small and micro businesses have provendifficult f6r NAFIN to reach.

Tlhe regulatory framework and supervision models are rapidly evolving in Mexico, especially fornon-bank financial institutions. This is a response to a longstanding gap in the regulation and supervisionof rural financial intermediaries (especially community based small savings mobilization institutions). It islikely that the Comisi6n Nacional Bancaria y de Valores (CNBV) will take the lead, using federations andother bodies as part of a delegated approach to supervision for rural financial institutions. At Negotiations,NAFIN provided a legal opinion that confirms that the financial and banking sector laws and regulationswill not negatively affect the implementation of the Project. The relevant financial and banking sector lawsinclude the Ley de Instituciones de Credito, Ley General de Titulos y Operaciones de Credito, LeyGeneral de Organizaciones y Actividades Auxiliares del Credito, Ley Organica del Banco de AhorroNacional y Servicios Financieros, Ley de Ahorro y Credito Popular, and other related regulations issuedby the CNBV.

Limited local participation in Business Development Services (BDS) design. Recent economicand sector work has highlighted some of the key policy and institutional issues affecting the Peninsula ofYucatAn and Mexico's economic performance (Grupo de Economistas y Asociados (1998). "Proyecto deFomento a la Competitividad de las Micro, Pequefias, y Medianas Empresas en Mexico: Coordinaci6nGeneral del Proyecto." BDS Project report prepared for SECOFI and the World Bank, January 28;Hallberg, K. (2000) "A Market-Oriented Strategy for Small and Medium-Scale Enterprises.". While stategovernments often support Federal Government business development services programs for small andmicrobusinesses as part of their development plans, these programs are often developed with little inputfrom the states of end users of BDS services. Market research and field interviews conducted duringProject preparation showed that microbusinesses are not well served by existing federal programs. There isgeneral recognition that a more market-oriented and decentralized strategy is needed in Mexico, addressingthe problem of collaboration.

Low levels of coverage of BDS programs for micro and small businesses. The current programsin Mexico have only reached a small share of the market and are largely unknown to the rest of the sector.This was confirmed during Project preparation by the market demand study conducted for the State ofCampeche. Both the recent research on federally-funded BDS programs in Mexico and the lessons ofinternational experience suggest that, in order to improve the coverage and quality of BDS relevant to the

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needs of small and microbusiness, the federal government should facilitate the growth of a moredecentralized, private sector-driven BDS industry. The Project will contribute to test a more decentralizedapproach in the role and management of publicly funded BDS programs by using information andcommunication technologies to evaluate lower-cost delivery mechanisms as well as piloting mixedpublic-private institutions to deliver BDS and microfinance.

Small number ofprivate providers and limited service options. Private providers of BDS are fewin the region. According to the market demand survey in Campeche, only 71 firms out of 331 hiredconsulting services in Campeche during 1999, primarily for accounting, taxes and integrated diagnosticsservices. The survey of firms in Campeche identified the main needs as training, information and advisoryservices in sales, business administration, marketing and production. However, these areas are not wellcovered by local or regional providers. In addition, despite national level improvements in ICT applicationsand accessibility, the Yucatan Peninsula lags far behind other parts of the country in ICT use.

Federal Government Strategy for Microfinance. Based on the economic, financial and povertytrends outlined above, and the growing role of the informal sector, the Federal Govemment has mademicrobusiness development a high priority. This emphasis reflects the Fox Administration's previoussuccessful experience with microfinance in Guanajuato State (the Santa Fe solidarity lending program).The Ministry of Economy (Secretaria de Economia) Office of Small and Medium Enterprises has launcheda new program designed exclusively to support microbusiness start-ups and another supporting existingmicrofinance institutions in 18 states (this does not include Campeche, Yucatan or Quintana Roo). Thishigh level of federal government interest in microfinance presents an important opportunity for the Project,and will make close coordination with the Ministry of Economy a high priority for the PCU.

NAFIN, also plays an important role in supporting small and microbusiness development. NAFINhas maintained a dialogue with the Bank over the past year on innovative ways to promote economicdecentralization and provide financial services to non-bank financial institutions that can reach lowerincome microbusiness operators. NAFIN is in a good position to play an expanded role in supporting themicrofinance industry, both in the Southeastern States and in other parts of the country, largely using itsown funds. However, NAFIN and the Bank recognize the need for flexibility in the project design andduring project implementation, in light of the evolving financial sector framework in Mexico, which couldhave a direct impact on NAFIN's mandate, and the regulatory and supervision arrangements for MFIs.

ICT-based Business Development Services Private/Public Partnership

National information infrastructure, in the form of telecommunications systems and networks,provides important physical conditions for improved economic performance, access to key technology andmarket information, and increased competitiveness. At the national level, Mexico has made importantimprovements in its information infrastructure. A comparison made by the Bank among the LatinAmerican countries indicates that Mexico ranks second in the total number of Intemet hosts and in the totalnumber of Internet subscribers.

Future progress in electronic commerce and ICT activities will depend on better legal frameworksand enforcement. Mexico has approved a law which established the Compranet system to promoteelectronic business transactions to respond to government procurement contracts. Under the law, Internetpurchase orders are considered to be a binding contract. The use of "electronic signatures" is alsoconsidered valid for Internet orders. The lack of clear legal recognition had hampered the growth ofbusiness transactions using the Internet in Mexico previously. Within a short time, Compranet hasregistered 1,830 firms from the States of Campeche, Yucatan, and Quintana Roo as eligible for governmentprocurement.

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Mexico has developed information communication infrastructure as well as the legal framework touse the new technologies to deliver business development services to microbusiness and to provide access toinformation, new markets and technologies. The basic IT infrastructure in telecommunications, intemetservice providers and programmers are available in the country according to the "e-business readiness"ranking recently published by the Economist Intelligence Unit (EIU). Mexico has been classified as acountry in the middle level range of readiness. The ranking combines the EIU's assessment of the businessenviromnent and a "connectivity rating" developed by Pyramid Research (the EIUYs communicationsdivision).

While the country has a high rating in "e-business readiness," the Southeastern States lag farbehind in this area. Yet there are significant initial efforts upon which the Project will be able to build.State and local governments and business associations, especially in Campeche, have taken important stepsto develop an infornation center oriented towards microbusiness clients. In Campeche, the informationcenter already provides e-mail access and web page design and maintenance services for local businessesfor a monthly fee of about 125 pesos (US$14). While basic infornation is readily accessible on the Internet(provided by BANCOMEXT, BANCOMER, Secretaria de Economia, and NAFIN), there is a lack ofsector-specific information, business management training packages and tools tailored to the needs ofmicroentrepreneurs with low levels of formal education.

There is also considerable scope for using distance learning methods for business training in theSoutheastern States, particularly given the existing or planned distance learning sites in the region of twomajor and highly successful Mexican distance training institutions (Instituto Tecnologico de Monterreyand Universidad Politecnica). However, experience with business management distance leaming has beenlargely limited to the leading Mexican enterprises and multinational firms and their suppliers anddistributors.

3. Learning and Development issues to be addressed by the project:

The learning agenda for the Project can be summarized in a single question: What set ofinstitutions, activities, and services are required to insure micro and small business access to appropriatelydesigned and efficiently delivered financial and business development services? By working with eligiblelocal microfinance institutions and at least one eligible ICT-based BDS infocenter, the Project willdemonstrate the advantages, risks, initial investment, operating costs, and institutional requirements forsustainable microfinance development and effective ICT-based BDS delivery. Since the local microfinanceand BDS industries have not had access to international best practices, this Project will be a critical sourceof technical information.

The Project will provide a leaming opportunity for NAFIN and the Participating States to adaptinternational best practices to local conditions, especially important in light of significant changes in thefinancial sector regulation and supervision framework for non-bank financial institutions. NAF1N has haddifficulties in the past providing services that reach the microbusiness sector, and has limited its supportlargely to conmnercial banks. The new approach uses regional staff to help the NAFIN headquarters PCUto carry out its monitoring and supervision responsibilities and to directly provide or link participatingMFIs and infocenters to a combination of financial and technical resources. This approach could hold thekey to a larger and more effective NAFIN effort to support this sector with financial services in the future.It will also help NAFIN to more clearly define the ways it can support microbusiness development in bothurban and rural markets, as financial sector regulations of non-bank financial institutions evolve. Thislearning opportunity is amplified by NAFIN's plans to undertake a regional or national replication as

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lessons are learned from the Southeast Regional Development Learning and Innovation Project.

A unique feature of this Project is that it provides both microfinance and BDS services, unlike theBank's initiatives in Guatemala and El Salvador. Therefore it is important to identify and measure thesynergies between the two components. The monitoring and evaluation system to be developed will help tomeasure such value-added gains. Since the two components are designed to reach a similar client base andwill be closely coordinating promotional and implementation activities, the two components will bedesigned to channel clients to other services financed under the loan when appropriate. The specificorganizational linkages to insure this close coordination will be developed by the institutions themselves,with support from the PCU.

One reason for confidence in the Project's ability to meet the learning agenda is the participatoryway in which the Project has been designed. A wide range of private sector, civil society, local and stategovernment, and universities have been involved in the development of a logical framework to guide projectdevelopment. The design of the components has been linked to existing initiatives promoting private sectordevelopment in two of the Southeastern States (Transformando Campeche, Visi6n 2025 de Quintana Roo).In addition, two regional seminars were conducted to discuss the different approaches for the components.The consultation process with the wide range of stakeholders will continue during Project launch and theimplementation.

4. Learning and innovation expectations:

DJ Economic Z Technical Z Social O Participationn Financial X Institutional El Environmental El Other

(a) Microfinance Services Component. For this component, the learning objective is to define thespecific set of MFI management systems, governance structures, promotion and product mix that can leadto the sustainability of eligible MFIs. The monitoring indicators for MFI sustainability will measure trendsin profitability (after adjustments for subsidies), efficiency, portfolio quality, and the level of outreach tolow income clients. The terms and conditions of the loans will be established in the Operational Manual,and will reflect the level of market demand, the experience and level of institutional development of theMFI, and other relevant factors.

The Microfinance Services Component will also provide access to international best practices andtools (such as business planning and financial projections tools, internal and external audit best practices,financial analysis and risk management for MFIs, delinquency management techniques, managementinformation systems and technologies to increase efficiency) to assist eligible MFIs to reach a full scale andsustainable level of operations. The Project will provide access for Eligible Microfinance Institutions totechnical resources such as the tools that have been developed and field-tested by the Consultative Group toAssist the Poorest (CGAP) on key topics such as financial management, business planning, internal andexternal audits for MFIs, cost allocations, and delinquency management. Begun in 1995, CGAP is aconsortium of 26 donors working in microfinance. The Bank is a founding member, provides significantfinancial support, and houses the CGAP Secretariat.

For evaluation purposes, the learning indicator to be evaluated (and presented in Annex 1) is asfollows: To demonstrate the MFI management systems, governance structures, promotion and product mixthat can lead to sustainability and outreach to the poor. MFI management systems means the operationaland strategic systems in place to provide senior management and the board of directors of the EligibleMicrofinance Institutions with the financial performance and other information required to make rationaldecisions that contribute to a more efficient and sustainable microfinance institution. Governance structures

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refers to the structure and role of the board of directors of the eligible MFI, including the use of regularmeetings to make strategic decisions and provide direction to management (including the review of audits,financial statements, new and updated policies, annual plans and projections, and other informationrequired in the efficient operation of the MFI). The promotion and product mix refers to the types of loans(with conditions and requirements) provided, savings products offered, and any special promotion andoutreach strategies and practices that are employed to reach new clients or provide existing clients withadditional or improved services.

(b) The ICT-based BDS Component. The ICT-based BDS Component will demonstrate theservices, local content, hardware and software systems required for Eligible Infocenters to reach breakevenpoint (the point at which operating revenues cover all operating expenses). The Eligible Infocenters willconnect microbusinesses to new market opportunities, linking them to new clients and suppliers in local andmore distant markets. The infocenters will provide a range of logistical services, and link microbusinessesto new sources of production technology and technical assistance. The development of the necessary localcontent and applications (related to business planning, marketing tools and databases) also represents animportant aspect of the learning agenda.

The component will take advantage of Bank project experiences in Guatemala and El Salvador, aswell as an existing NAFIN electronic commerce initiative. These experiences will enable the component toefficiently provide local content and applications that match the needs of small and microbusiness operatorsand promote firm growth and profitability. The PCU will insure that project activities are closelycoordinated with other ongoing federal and state government and private initiatives in ICT-based BDS forsmall and microbusinesses.

The Project will provide practical experience for the regional staff and the private sector in assessingthe economic viability of the use of ICT to deliver BDS to increase service outreach and effectiveness. Bythe end of the Project, the monitoring and evaluation system will allow for clear identification of both theeconomic costs and benefits to a variety of actors, including microbusiness operators, consumers, BDSproviders, and local governments.

The financial viability of ICT-based BDS provision hinges on market development and costrecovery. The component will support efforts by Eligible Infocenters to develop attractive products andservices, local content, cost-effective pricing strategies and to choose convenient sites in an effort to insurethe financial viability of Eligible Infocenters (see Section C. Project Description Summary for specificeligibility criteria). The monitoring indicators for Eligible Infocenter activities will include costs perbeneficiary, delivery methods, and the barriers faced by small and microbusinesses to these newtechnologies and tools.

To meet this part of the learning agenda, there are a few key technical and technological challengesto be overcome. The component needs to assist the participating Southeastern States to create an effectiveinterface with microbusinesses, suppliers, programmers, ISP providers, universities to develop IT software,local content and training tool kits that respond to the needs of local firms in the region. Informationtechnology and distance leaming equipment needs to be operated and maintained adequately, with user timestandards set to insure timely response time. An orientation to end user needs and the development of localcontent is critical for the ICT staff charged with the development of appropriate small and microbusinessapplications. The infocenter staff needs to be trained in efficient use of systems and become very familiarwith the needs and restrictions faced by small and microbusiness clients.

(c ) Institutional Strengthening and Capacity Building. This component strengthens the PCU and

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establishes a monitoring and evaluation system. For evaluation purposes, the learning indicator to beevaluated for this component will be the ability of the PCU to provide timely, accurate, detailed informationon the performance of the eligible MFIs and the Eligible Infocenters, project costs, and other project-relatedinformation. The evaluation will also cover the ability of the PCU to to implement the Project, carry outannual reviews, consultation, and coordination.

(d) Follow-on Development Objective. There is a strong likelihood of a follow-up project forNAFIN, possibly financed by the Bank. This Project would cover states outside of the Southeast Region ofthe country, and would be a direct result of the documented results of the Southeast Regional DevelopmentLearning and Innovation Project's activities. The key indicator for the follow-on development objectivewould be the number of potentially sustainable MFIs and infocenters establishing or expanding operationsafter receiving information on performance and lessons leamed from the Southeast Regional DevelopmentLearning and Innovation Project. In terms of the infocenter activities, replication is likely with theSecretaria de Economia, which is actively involved in pilot activities in this area. For microfmance,replication is likely by NAFIN (in other regions of the country) and by the Secretaria de Economia, whichhas recently launched a pilot initiative along these lines.

C. Project Description Summary

1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed costbreakdown):

Indicative Bank- % ofComponent Sector Costs % of financing Bank-

(US$M) Total (US$M) financingMicrofmance Services Financial Sector 7.43 70.1 2.93 58.6

DevelopmentDelivery of Business Development Financial Sector 1.02 9.6 0.68 13.6Services through the use of ICT DevelopmentInstitutional Strengthening and Financial Sector 1.65 15.6 0.89 17.8Capacity Building DevelopmentUnallocated Institutional 0.45 4.2 0.45 9.0

DevelopmentTotal Project Costs 10.55 100.0 4.95 99.0

Front-end fee 0.05 0.5 0.05 1.0Total Financing Required 10.60 100.5 5.00 100.0

2. Institutional and implementation arrangements:

Overall Objective: To contribute to microbusiness development in Mexico by demonstrating bestpractices in the form of microfinance institutional development and an ICT-based BDS model. This willnot be measured by the Project, but is an important part of the overall context of the Project.

Project Development Objective: The objective of the Project is to assist Participating States intheSoutheast Region of Mexico and the private sector to learn about (a) the requirements of sustainable

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microfinance methodologies to promote access to financial services to unserved populations, and (b) the useof information commnunications technology (ICT) to deliver business development services (BDS) tomicrobusinesses in a cost effective and sustainable manner.

Microbusiness Development

I . I~~~~~~~~~~~~~~~

Demonstration Models

|Eligible Traditional | | Eligible Scctor | |Eligible Business | MFIs -specific MFls | Associations l

Model Eligible Infocent Eligible Infocenter Eligible Infocenter

.. ....... ... .......

Target Solidarity Rural commodity Memberclients Groups of low Producers and processors microbusiness

............... Income clients,........... .... .....................

Replication Sectoral and GeographicGeographicStrategy Geographic

............... .....-... ..................

Participating States. An eligibility system has been established so that any Southeastern Statecould participate, if that State has been deemed by the PCU to have met the eligibility criteria provided inthe Operational Manual and has been reviewed in a due diligence process by the Bank. The eligibilitycriteria for Participating States as well as the process required to reach the determination of eligibility, havebeen agreed upon and are described below.

Preliminary Determination of Eligibility of a State

I. Participating States must be in the Southeast Region of Mexico and provide written confirmation ofinterest on the part of the State Government, private sector organization or civil society organization,including a commitment of funds to support project activities (for one or all project components).

2. There should be a large number of unserved microbusinesses - confirmed by census information orrecent studies of the sector

3. At least one existing microfinance institution (if the Microfinance Services Component) or at least oneprivate sector association or other group (if the ICT-based BDS component) should express writteninterest to NAFIN in participation in the Project.

4. The NAFIN headquarters office and the PCU should provide written confirmation to the Bank statingthat the Southeastern State complies with all eligibility criteria and that there is no duplication of efforts

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with other national programs that offers similar services for microbusinesses.

The Process for Determination of Eligibility of a State

1. Discussions will be held between Bank staff responsible for project supervision, the PCU andrepresentatives of the interested State Government and the private sector. In addition, consultation willbe held with civil society to determine the potential for widespread participation in project activities.

2. There will be a joint determination that all conditions are in place to enable the PCU and Bank toperform their respective responsibilities of supervision and monitoring, as well as evaluation of theProject.

3. The Bank will make the final determination based on the infornation provided and in consultation withthe PCU. The determination by the Bank will be based on the likelihood that project-supportedactivities would contribute to the learning related to the Project Development Objective.

4. The Bank will send a written final confirmation of the acceptance of the State as a Participating State.

Overall Project Management and Supervision.

Project Coordination Unit. The PCU is located in NAFIN. NAFIN will be the executing agencyfor the Project, but will not act as financial agent of the Guarantor. The process for NAFIN to borrow andact as the executing agency for the Project is as follows: (i) NAFIN will submit an application (Solicitud deGesti6n) to the Secretaria de Hacienda y Credito Publico (SHCP) for the authority to request and obtain aloan from the Bank, (ii) SHCP will issue the Authorization (through an Oficio de Autorizaci6n deEndeudamiento), and (iii) NAFIN will accept the responsibilities of borrowing and will undertake Projectexecution through a Resolution (Acuerdo del Consejo Directivo de NA FIN). The issuance of the Acuerdodel Consejo Directivo of NAFIN is a Condition of Loan effectiveness.

The PCU will be maintained at all times in accordance with terms of reference, staffing andresponsibilities agreed with the Bank and will oversee all administrative, financial, procurement,disbursement, and logistical aspects of project implementation, including the supervision of all Subprojectswith Eligible MFIs and Eligible Infocenters. The PCU will also prepare reports, coordinate reports fromEligible Microfinance Institutions and Eligible Infocenters, and will be responsible for the annual reviewsand other evaluations. Specifically, the PCU will have the following functions and responsibilities: (i)monitoring the implementation of the Project and ensuring effective coordination among the staff andinstitutions responsible for the implementation of the Project; (ii) preparing and submitting to the Bank thePMRs (described in Section 4.4); (iii) carrying out of the procurement of goods and consultants' servicesrequired for the Project (pursuant to the provisions in Annex 6); (iv) overseeing the general administrationof the Project, with respect to Loan proceeds withdrawal, financial management, accounting and auditing;(v) reviewing, jointly with the Secretaria de Hacienda y Credito Publico and the Bank, the progressachieved by the Borrower in the implementation of the Project on the basis of the annual reports (describedin Section C.3. below); (vi) monitoring progress achieved by the Eligible Microfinance Institutions and theEligible Infocenters in the implementation of their respective activities under the Project, including theSubprojects; (vii) identifying any possible obstacle or difficulty affecting or threatening to affect projectimplementation; and (viii) developing and implementing a monitoring and evaluation system to carry out anevaluation of the impacts of the leaming and innovation programs of the Project.

NAFIN will play a strong supporting role for the PCU in various aspects of project management.The following project activities will be the responsibility of specialized areas within NAFIN, which willcoordinate these activities closely with the PCU: (i) operation of the Special Account such as withdrawal

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applications and coordination of Special Account and annual audits, (ii) preparation of Bank financialmanagement reports (as input to the PMRs), (iii) coordination of the project annual audits, and (iv) projectflow of funds such as payments. The incremental operating costs of the PCU will be financed by the loanson a declining basis. (See Annex 6 for details.)

The PCU will be, at all times during the execution of the Project, headed by a Project Coordinator,with qualifications, experience, functions and responsibilities satisfactory to the Bank. The ProjectCoordinator will be asssisted by technical and administrative staff in adequate numbers and withqualifications and experience satisfactory to the Bank, including, inter alia: (i) an accountant withtechnical expertise in financial management matters (the Project Accountant); (ii) a specialist inprocurement procedures, guidelines and contracts (the Procurement Specialist); (iii) an officer responsiblefor administrative and operational matters (the Administrative Manager); and (iv) Regional Staff assignedto the Borrower's office in the State of Yucatan (Merida), including, inter alia, a technical specialist forthe Microfinance Services Component and a technical specialist for the ICT-based BDS Component. Inaddition to monitoring, preparation of reports, coordination and other responsibilities discussed atNegotiations, the PCU will be responsible for carrying out ongoing consultations with civil society and willconduct an impact evaluation of project activities (as described in Section 6.4).

The Regional Staff will be responsible for supervision and monitoring of the Subprojects that havebeen approved under the Project, as well as the reports which meet the requirements of NAFIN and theBank (especially regarding financial management issues). The Regional Staff shall be responsible, interalia, for: (a) ensuring that each Eligible Microfinance Institution and each Eligible Infocenter prepares andsubmits, in a timely fashion, annual reports and business plans; (b) supervising and monitoring theimplementation of the Subprojects approved for financing under the Project; (c) assisting with thepreparation of reports and documentation related to financial management requirements under the Project;and (d) compiling and disseminating the lessons learned throughout project implementation.

The PCU will receive ongoing support from the Unidad de Financiamiento Especial, NAFIN'soffice in charge of procurement.

At all times, the Borrower shall provide, promptly as needed, the funds, facilities, services, staffand other resources required for the discharge of the functions of the PCU.

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Project Organizational Mexico City HQ Chart

Project Nlnagement Staffing in NAFIN:. ~~~~~Projec Coociator

Unit Adminisative ManagerProent Spedalist

NAF1N Promotion Ned AccountatMcrofinarnce Speciaist& Technical Assist. Unit ICT-based BDS Specialist

Infocenters inPossible MFI's in Paitipating States in the Southeast Region Participating

Soudieastem States

Possible Beneficiaries: Micrbusiness& Small busnessEBusiniess Chamubers

Rufal Rural Small Rural/Urban Individual Bus Assoc. ProducerSolidarity Scale Honey Traders; Urban Members UfiversitaesGroups Producers Producers (Microbuis) (Microbus) Agroproducers

(Solidarity Hoey pdcerGroups) ISP providers

To support the PCU, NAF1N will allocate an adequate budget for the PCU every year so that itcan purchase necessary equipment, such as computers, printers, copy machines and software packages, andto cover the costs of training for PCU headquarters and regional staff in the technical, management andadministration skills required for overall project coordination, monitoring, and reporting. NAFIN willcover the incremental costs of NAFIN state offices participating in the supervision and monitoring ofproject activities.

Operational Manual. The Operational Manual will contain detailed procedures for the carryingout of the Project, including, inter alia: (i) criteria to determine the eligibility of the States, MicrofinanceInstitutions, Microbusinesses and Infocenters for the purposes of receiving financing under the Project; (ii)terms, conditions and standard contractual docunentation for the provision of Intermediary Loans,Subloans and Grants financed under the Project; (iii) terms, conditions and procedures for the review,assessment and approval of Subprojects financed under the Project; (iv) detailed terms and procedures forthe establishment and implementation of accounting, auditing and financial management systems for the

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Project; (v) procedures and requirements for the procurement of goods and consultants' services financedunder the Project, including the Subprojects; (vi) terms of reference and procedures for the design andimplementation of the evaluation and consultation activities with all stakeholders; and (vii) terms andstipulations for Intermediary Loan (Type A) Agreements to Eligible MFIs, Intermediary Loan (Type B)Agreements to Eligible Infocenters, Grant Agreements to Eligible Infocenters, and Subloans to EligibleMicrobusinesses.

The Operational Manual will set up processes, procedures, standard formats and contracts, andmonitoring and evaluation systems to insure that the Eligible Microfinance Institutions and EligibleInfocenters carry out their activities efficiently and in conformity with appropriate administrative, financial,banking, microfmance, information communications technology, participatory, environmental, and socialstandards and practices. The Operational Manual will also describe the key elements of business plans foreligible MFIs and Eligible Infocenters, including systems development, product development, and theoutreach activities to insure the participation of unserved populations (including, inter alia, women andindigenous populations, as agreed during Negotiations).

Procurement. The Assessment found that NAFIN has adequate systems to administer the funds,monitor their use, and provide oversight as well as technical assistance on financial management to theRegionalPCU staff. The overall risk assessment is considered to be average. The risk assessment is low forthe following sections: (i) legal aspects, and (ii) project cycle management. The risk level has beendetermnined to be average for the following sections of the assessment: (i) organization and functions; (ii)support and control systems; (iii) general procurement environment; and (iv) private sector assessment.The PCU has already prepared an acceptable Procurement Plan for the Project.

The PCU, with support from NAFIN's Unidad de Financiamiento Especial (UFE) will beresponsible for: (i) preparing tender documents, (ii) calling for bids; (iii) evaluating and comparing bids andconsultants qualifications, (iv) awarding contracts, (v) signing the contracts, and (vi) maintaining all thecorresponding records. Because the PCU has no experience in procurement, a procurement specialist willbe part of the PCU team.

Because the amount of the procurement required by the Project, no foreign suppliers of goods areexpected to participate and no ICB procedures will apply under the Project. For the proposed Project, itwas agreed to follow Bank's Guidelines (January 1995 revised January and August 1996, September 1997and January 1999 editions). The latest version of Standard Bidding Documents agreed by Mexico and theBank for NCB will be used, and national shopping procedures also will be applicable. (Goods estimated tocost $50,000 equivalent or less per contract, up to an aggregate amount not to exceed $650,000 equivalent,may be procured under contracts awarded on the basis of national shopping procedures in accordance withthe provisions of paragraphs 3.5 and 3.6 of the Bank's Guidelines). Only Individual Consultants will beemployed and will be selected on the basis of their qualifications for the assignment. Paragraph 5.1 to 5.3of the Guidelines "Selection and Employment of Consultants by World Bank Borrowers" (January 1997,revised September 1997 and January 1999 editions) will apply.

It was agreed at Negotiations that, in order to facilitate the large number of small transactionsinvolved in the Microfinance Services Component (for subloans for eligible investment subprojects), aprocurement category of commercial practices will be used, in accordance with procedures acceptable tothe Bank. In accordance with Bank Guidelines, the PCU has prepared a General Procurement Plan for theProject that has been reviewed by the Bank. This Plan is satisfactory, and its implementation will ensuretimely project execution. The Bank Implementation Unit in Mexico will perform two post-reviews ofcontracts prepared by the PCU and submitted to the Bank each year. (Annex 6 provides additional

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information on procurement issues such as categories, prior review requirements, thresholds, and relatedinfonnation.)

Financial Management System and Project Management Reports (PMR). It was agreed duringNegotiations and according to the assessment of the Project's financial management system, that financialmanagement arrangements are adequate as they are in compliance of minimum financial managementrequirements.

A follow-up assessment (based on the "Assessment of Financial Management Arrangements inWorld Bank-financed Projects" guidelines dated June 30, 2001) was carried out in July, 2001. Theconclusion of this review were: (a) the existence of an acceptable Financial Management System (althoughnot ready for Project Management Reports PMR until July 31, 2002); and (b) the agreement reached on theaction plan to allow for the issuance of PMRs. Specific implementation arrangements for each componentare presented below (See Section 4.4 for more detailed information on financial management issues andPMRs).

Microfinance Services Component Implementation Arrangements

Definition of an Eligible Microbusiness. The definition of an Eligible Microbusiness for projectpurposes is a business with up to 100 employees (which is based on a nationally accepted definition of amicrobusiness; INEGI 2000). Given the average loan size and methodologies used by the MFIs that arelikely to be eligible for project support, the size of an eligible microbusiness is likely to be much smaller.In most cases, Eligible Microbusinesses are likely to be the self-employed and businesses with no more thanfive employees. Eligible microbusinesses will also not undertake the production or processing of tobaccoproducts, will not operate tanneries or other businesses that could cause negative impact on theenvironment, will not use pesticides or other inputs which are not approved by the World HealthOrganization, will not purchase luxury goods, and will not be involved in petroleum production, electricityproduction, or the production of firearms and related products. The Operational Manual will provide a listof economic activities that are not eligible under the terms of the Project.

Determining the Eligibility of a Microfinance Institution. The Operational Manual establishesclear criteria for the eligibility of microfinance institutions, which include (i) the quality of the loanportfolio (using portfolio at risk at 30 days), (ii) the adequacy of loan loss reserves, and (iii) the onlendingterms to Eligible Microbusinesses. Eligible MFIs which fail to meet the eligibility requirements will facesanctions for non-compliance.

Key elements of the assessment described in the Operational Manual include the following nineareas:

1. Establishment of the trust fund arrangement (Fideicomiso) authorized by NAFIN2. Adequacy of guarantees for the amount of the active loan portfolio3. Equity position (unaffected capital of at least one million pesos (US$110,000)4. Sufficient management and line staff to ensure sound management of resources, and an adequateaccounting system5. Relevant experience for management and key personnel6. Legal consultants or staff to resolve loan contract and other legal issues7. Adequate offices, equipment and computer systems8. Adequate quality of the loan portfolio9. Adequate methodologies and outreach activities

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Measuring the Quality of the Eligible MFI's Loan Portfolio. The initial review to determineeligibilty and subsequent reviews will assess the performance of Subloans supported by the Project andperformance of the overall loan portfolio of the eligible MFI. The monitoring of the portfolio will beconducted on a monthly basis by the PCU Microfmance Technical Specialist, and the determination ofcontinued eligibility of the microfinance institution will be made by the PCU Coordinator at theheadquarters office.

Determining the Reserve Requirements. Based on the guidelines included in the OperationalManual, reserve requirements are established based on the assessment of the quality of the loan portfolio,using a standard aging measure and calculating the average number of days past due of active loans. Thesystem will be adjusted as required by any new financial sector laws, supervision frameworks, andregulations.

Investment Subprojects for Eligible MFIs to provide Subloans. Proposals for InvestmentSubprojects will be presented by Eligible Microfinance Institutions to the PCU. Once the IntermediaryLoan (Type A) Agreement is approved, the Eligible MFI will have access to an Intermediary Loan (TypeA) financed under the Loan at a commercial rate of interest linked to the intermediary market interest rate(TIIE, the interbank lending rate). The Tasa de interes interbancario de equilibrio (THE) was establishedby the Banco de Mexico in the Diario Oficial de la Federaci6n, Volume 1598, No. 17, Section 1, page 11;23 March 1995. Eligible MFIs will be able to determine the interest rate charged on an investmentsubproject loan to an eligible microbusiness, and this rate will be sufficient to cover all operating andfinancial costs. The Eligible Microfinance Institution will sign an Intermediary Loan (Type A) Agreementwith NAFIN which will specify the terms and conditions, monitoring indicators, schedule of disbursements,and other requirements. The amount of the credit line provided in the Intermediary Loan (Type A)Agreement will be determined based on a technical assessment by the PCU Microfinance TechnicalSpecialist of (i) the existing systems of the MFI; (ii) the demand for loans for eligible subprojects; (iii) therequirements for MFI institutional development (as expressed in the Institutional Development Subproject,based on the outline and terms and stipulations provided in the Operational Manual); and (iv) other relevantconsiderations. The Eligible Microbusinesses must provide funds to complete the financing of theInvestment Subproject. All Intermediary Loan (Type A) Agreements, including the standard terms ofSubloans, must be in agreement with the terms and stipulations agreed upon and included in theOperational Manual.

Institutional Development Subprojects for Eligible MFIs. The Eligible MFI must submit anInstitutional Development Subproject, which demonstrates the ways in which funds provided under theterms of the Intermediary Loan (Type A) Agreement by the PCU could be used to improve managementsystems, provide training to staff, develop new products, and take other concrete measures to improve thesoundness of the MFI and its ability to manage a larger loan portfolio. All Institutional DevelopmentSubprojects must be acceptable to the Bank.

Subloans to Eligible Microbusinesses. Subloans may be provided to end users for a broad range ofproductive investments (including manufacturing, services and commerce) and may include workingcapital, fixed assets, and other needs. The aggregate amount of Subloans to an Eligible Microbusinessshall not exceed US$8,000 at any time. The term of the loan, the interest rate, the repayment schedule, thecollateral requirements, and related issues are all determined by the Eligible MEI. The use of funds isrestricted to eligible subprojects as listed in the Operational Manual, which includes a "negative list" ofInvestment Subprojects. All terms and conditions of the Subloan application, fees, promotion and deliverymethodologies, and the Subloan approval process will be reviewed periodically by the PCU to insure that

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they do not present barriers to microbusiness operators. Limits have been set for working capital loans(maturity not to exceed 24 months) and for fixed asset loans (maturity not to exceed 48 months).

Microfinance Operating Manuals. Eligible MFIs will provide copies of their operating manualsand other manuals to the Regional Staff of PCU. These manuals should include (i) a description of theaccounting, auditing, subloan tracking, and financial reporting systems; (ii) procedures for the procurementof goods and services; (iii) procedures for selection of staff and consultants, and related human resourcematters (salaries, staff evaluation, incentives, etc.); (iv) terms, conditions and model documentation for theprovision of subloans; and (v) procedures for consultation with stakeholders. (Indicators to measure theperformance of the Eligible MFIs are listed in Annex 1.)

Sanctions for Non-compliance. The PCU will apply the existing NAFIN system of sanctions,including suspension of the credit line and a declaration of ineligibility of the microfinance institution forproject purposes. This is done to insure sound use of the funds, as well as to comply with the existingregulations and legislation (Normatividad Financiera, inter alia, Ley de Instituciones de Credito; LeyGeneral de Titulos and Operaciones de Credito). The PCU will inform the Bank in a timely way in theevent of the declaration of ineligibility of a microfmance institution. These procedures and practices will beadjusted in the event that new regulations are put in place as part of the financial sector reform currentlyunderway.

ICT-based BDS Component Institutional and Implementation Arrangements

For the purposes of this Project, an infocenter is any of the private comrnmercial companies ornon-profit entities which provides information and communications technology-based development servicesin a Participating Southeastem State. The basic infocenter will offer a range of business-oriented services,market information and databases, sources of key inputs, logistical databases, consulting services, financialprojection models, videoconferencing, and business management training and tools tailored to local clientneeds. The infocenter will use promotion and delivery techniques to insure strong outreach to the localbusiness community, and will emphasize full cost recovery through user fees.

An infocenter will be eligible for project support if it has a business plan (including a financialmodel, a marketing plan, and proof of technical and commercial viability), adequate staffing, and links tolocal business and civil society partners which have made financial and local content contributions. TheEligible Infocenter will provide proof of legal registration as a private commercial company or non-profitentity established in the territory of any of the Participating States, and be registered with the RegistroFederal de Contribuyentes. Infocenter management will agree to provide specific BDS to small andmicrobusinesses in a cost-effective way, with no significant barriers to access for all local businesses.

Start-up Subproject Grants. The Eligible Infocenter will submit a Start-up Subproject proposaland may receive a grant to cover start-up investments and initial operating costs. Grants will range up toUS$100,000 per Eligible Infocenter and will be determined by the PCU Coordinator and TechnicalSpecialist for the ICT-based BDS Component (and will be in accordance with agreements reached with theBank). The decision will be based on the proof of market demand for infocenter services in a particularmarket, the level of preparedness reflected in the business plan and technical discussions with local partners(such as business associations and ISP providers). Grants will be approved and allocated based on therequirements, terms and conditions for such agreements as detailed in the Operational Manual.

Commercial Subproject Loans for Infocenters. The Eligible Infocenter will enter into anIntermediary Loan (Type B) Agreement with NAFIN to determrine the amount of funding provided for

- 18 -

full-scale development of the infocenter. The loan for the Commercial Subproject will bear a commercialrate of interest (linked to TIIE) and will be governed by the terms and conditions set forth in theOperational Manual. The commercial subproject will specify the financial requirements based on anannual basis and by expense category for reaching the breakeven point. The Technical Specialist for theICT-based BDS Component will review the proposed Commercial Subproject with local experts and theProject Coordinator to determine the technical feasibility of the Commercial Subproject and determine theadjustments required. All Intermediary Loan (Type B) Agreements and Grant Agreements must be inagreement with the terms and stipulations agreed upon and included in the Operational Manual.

3. Monitoring and evaluation arrangements:

ICT-based Project Monitoring and Evaluation System. The PCU will supervise the Project withan innovative ICT-based monitoring and evaluation system, which has already been designed. The systemhas five modules: (i) management and monitoring by state and by component; (ii) output and outcomeevaluation; (iii) document management; (iv) administrative and financial management; and (v) technicalassistance and training through the use of ITC systems. To maximize learning for all participants, aproject web page is being designed to provide information on project advances and lessons learned, and toaddress technical, financial and management issues that arise during implementation. There will also beannual reviews to measure and discuss the advances, problems, and lessons of the Project. The design ofthe annual reviews by component is provided below.

Baseline Data Collection and Monitoring of Microfinance Services Component. Baseline datawill be collected as Eligible Microfinance Institutions qualify for project services and begin to serve newclients (Eligible Microbusinesses). Key baseline data for Eligible Microfinance Institutions will includepre-project status in terms of (i) efficiency, (ii) profitability (adjusted for subsidies), (iii) operationalself-sufficiency, (iv) portfolio quality; and (v) the number of active clients (disaggregated bycharacteristics). Start-up microfinance institutions will be determined to be eligible only if they have thesystems in place to insure that this baseline infornnation can be collected over time. Baseline data forEligible Microbusinesses will include key client characteristics. All actions required will be undertaken toensure an accurate portrayal of the participation during the Project of civil society, including inter aliawomen and indigenous populations.

The PCU will monitor the loan portfolio performance of the Eligible Microfinance Institutions,using the system presented in the Operational Manual [largely based on the NAFIN Credit Manual (Tablero de Supervisi6n)] published in November of 2000 and amended in January and February of 2001.The NAF1N offices in the participating Southeastern States will assume primary responsibility for ongoingmonitoring of the Project's activities, using the monitoring indicators provided for this component. The keymonitoring indicators for this component are consistent with those advocated by CGAP and used byinternational rating agencies. A full external evaluation will be conducted at the end of the third year of theProject. In addition, the PCU will monitor the client characteristics listed above and collected in thebaseline data surveys.

Baseline Data Collection and Monitoring of ICT-based BDS Component. Baseline data will becollected for the component through client surveys, which identify the client's characteristics and other keyfactors that will illustrate the economic and social impact of the infocenters. Baseline data for eligiblemicrobusinesses will include key client characteristics. All actions required will be undertaken to ensure anaccurate portrayal of the participation during the Project of civil society, including inter alia women andindigenous people.

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The PCU will monitor the use of funds provided under the Grant Agreements and the IntermediaryLoan (Type B) Agreements and the performance of the infocenters, comparing the targets presented in theStart-up Subproject and the commercial subproject with actual performance. This will be achieved througha periodic review of the infocenter made during PCU staff site visits and reviews by consultants selected bythe PCU. The PCU will conduct an annual review of program performance for Bank review, annualreviews and an impact assessment evaluation at the client level. A full extemal evaluation will be conductedduring the third year of the Project.

Annual Project Implementation Reports and Plans. The PCU will prepare and furnish to theBank, by not later than April 30 of each year (starting in 2002) and with formats acceptable to the Bank:(i) a project implementation report, including a detailed description of the activities under the MicrofinanceServices Component and the ICT-based BDS Component completed under the twelve months preceding thedate of the report; (ii) an audited annual financial statement, for each Eligible Microfinance Institution andeach Eligible Infocenter; (iii) an annual plan, including an annual budget, implementation timetable fortraining programs, and a financial plan (including contributions from public and private sources) for theactivities proposed for implementation during the next calendar year; and (iv) a progress report, includinglessons learned during project implementation. The Project implementation progress report should analyzethe efficiency of the activities of the Eligible Microfinance Institutions and Eligible Infocenters inconformity with appropriate administrative, financial, banking, microfinance, infornation communicationstechnology, participatory, environmental, and social standards and practices, as agreed upon atNegotiations.

Annual Reviews of Microfinance Services Component. Based on the annual reports describedabove, the PCU, jointly with the Bank and the Guarantor, will hold annual reviews by June 30 of each year(starting in 2002) to determrine the actions needed to strengthen the component's performance (includingeligibility criteria, reporting, the outreach and financial performance of Eligible Microfinance Institutions).The annual review will identify barriers to access by different types of clients, and will develop remediesand a plan to track their effectiveness. This review will include a comparison of annual targets (developedbased on the component's monitoring indicators) and actual levels of achievement (in areas such as thenumber of active clients, dropouts, adjusted profitability) as reported by the PCU in the annual reports.

Annual Reviews of ICT-Based BDS Component. Based on the annual reports described above, thePCU, jointly with the Bank and the Guarantor, will conduct annual reviews by June 30 of each year(starting in 2002) using the baseline study covering (a) market research and analysis for each infocenter,(b) data provided by participants and users of the infocenters, (c) qualitative and quantitative informationfrom the logical framework in each state, and (d) a survey undertaken for micro and small businesses in thetarget area prior to opening the pilot infocenter and each year compared to a control group. Monitoringindicators for each infocenter will include the number of clients paying to use the infocenter facilities, thelevel of cost coverage of the infocenter, the availability of local content and business-related tools, and thelevel of client satisfaction determined by surveys.

Annual Review of the Institutional Development and Capacity Building Component. The PCU,jointly with the Bank and the Guarantor, will conduct annual reviews by June 30 of each year (starting in2002) to review the effectiveness of the monitoring and evaluation activities (in terms of costs, accuracy,timeliness of information, and other aspects), as well as all PCU activities involving the overallcoordination of project planning, operation, resource management, evaluation, supervision resourcemanagement, evaluation of program operation and reporting, auditing, budgeting and financial reporting,intemal controls, procurement and other aspects of project management.

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D. Project Rationale[This section is not to be completed in a LIL PAD. Rationale should be implicit in paragraph B: 3.]

E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8)

1. Economic (see Annex 4):[For LIL, to the extent applicable]O Cost benefit NPV=US$ million; ERR = % (see Annex 4)* Cost effectivenessO Other (specify)

The Project promotes services and institutional arrangements that connect small andmicrobusinesses in the participating Southeastern States to market opportunities (through the developmentof the innovative infocenters) and finance the costs of pursuing such opportunities (through project supportfor Eligible Microfinance Institutions to onlend to eligible microbusinesses). There are strong synergies inthe combination of services financed under the Loan. By combining access to financial services, marketinfonnation and technology, clients will be able to identify and take advantage of new market opportunities,diversify products, and create jobs.

The expected economic effects of the Microfinance Services Component include increased jobstability, increased income for microbusiness operators, business transformation (from a subsistence levelof production to a commercially viable level), and a decreased risk of business failure through betterinforned product design and market diversification. Studies conducted during project preparationillustrate that the annual effective cost of credit for local microbusinesses in Campeche, Yucatan, andQuintana Roo often exceeds 100% in real terms. The interest rates paid by microbusinesses served by themicrofinance institutions that are most likely to be deemed eligible for project support charge an interestrate of 30% to 40% in real terms, representing a huge economic benefit for microbusinesses. (Annex 2aprovides additional information on the four MFIs that are most likely to be deemed to be eligible based onthe criteria established in the Operational Manual.)

For the ICT-based BDS Component, the infocenters are likely to have a significant economicimpact on the income of clients, since the infocenters are designed to provide valuable and timelyinformation on product and packaging design, new markets, sources of raw materials, and suppliers ofmachinery and equipment. By increasing the options a small or microbusiness faces, the infocenter willhelp to move these businesses from marginal status to full participation in the local and regional economy.

2. Financial (see Annex 4 and Annex 5):NPV=US$ million; FRR= % (see Annex 4)[For LIL, to the extent applicable]

For the Microfinance Services Component, the operational self-sufficiency and potential for fullfinancial sustainability of three microfinance institutions that are likely to become eligible for projectservices were reviewed during project preparation, to ensure that there will be demand for componentservices (see Annex 2a for specific reviews of the four institutions). A business planning exercise (basedon the Microfm model advocated by CGAP) was used to reach this deternination. Given the low cost oflabor and the interest rates for similar financial services by the target client group and the scale of demand

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for such services, it is possible that the eligible MFIs could reach full operating self-sufficiency (operatingcosts covered by fees and income generated by the loan portfolio) during the life of the Project.

For the ICT-based BDS Services Component, it is expected that the infocenters will becomeself-sufficient by generating operating income that covers all operating costs and equipment. The Projectwill support the development of a simulation model as part of the preparation of the initial business plan foreach infocenter. (See Annex 2b for additional information on costs and the break even point of a typicalinfocenter, which has been estimated to be within 24 months of start-up.)

Fiscal Impact:

Not applicable

3. Technical:[For LIL, enter data if applicable or 'Not Applicable']

The technology involved in the ICT-based BDS Component is relatively advanced and rapidlyevolving, the Project will provide the infocenters with technical support staff that have experience with thelatest e-commerce, distance learning and adult education techniques. The Microfinance ServicesComponent will also provide access to recent technical advances in MFI management, includingmanagement information and loan tracking systems, audit practices tailored to the special risks ofmicrofinance operations, and recently developed approaches for measuring client satisfaction anddeveloping new products.

4. Institutional:Implementation period: 4 years

4.1 Executing agencies:

NAFIN will be the executing agency of the Project. NAFIN has a proven record in working withthe Bank in several projects in which it acts as a financial intermediary. In 2000, NAFIN developed a newcredit analysis and supervision system and supporting operating manual, tailored to non-bank financialinstitutions. Key topics include a systems review, portfolio quality, sanctions, loan supervision, leverage,and solvency. NAFIN regional staff in the Participating States will be trained in this new system, and willbe responsible for timely collection and analysis of key financial and outreach information. NAFIN is wellprepared to take on many of the key responsibilities related to project execution, although the PCU has onlyrecently been established and is not yet fully staffed.

4.2 Project management:

Project Coordination Unit (PCU). Responsibility for the Project will rest with the ProjectCoordination Unit (PCU) to be established within NAFIN. Various departments of NAFIN haveparticipated in project preparation, including Operations (Direcci6n de Operaciones), Intemational Affairs(Direcci6n Adjunta Internacional), Legal Department (Direcci6n Adjunta Legal), Financing (Direcci6nAdjunta de Financiamiento) and the Fiduciary Department (Direccion Fiduciaria). NAFIN has developedsignificant project management capacity with previous and ongoing Bank projects. For these projects,NAFIN has met the Bank's financial management requirements, as it has an adequate structure for internalcontrol, financial reporting, procedures for budget control and a computerized information system whichsupports accounting processes and transactions. These arrangements will be fully satisfactory to the Bankwhen the PCU has been fully created and staffed, and there is a specific system for project management.An Action Plan was agreed to at Negotiations. As of September 1, 2001, the Project Coordinator,Administrative Manager, Procurement Specialist, and Project Accountant had been identified, and werealready working on project preparation within NAFIN's Project team. The Bank will only approve legal

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evidence of formal appointment.

It was agreed that there are two conditions of Loan Effectiveness related to the projectmanagement: (a) establishment of the PCU and the identification and selection of the Project Coordinator,Administrative Manager, Procurement Specialist, Microfinance Technical Specialist and ICT-basedBusiness Development Services Specialist; and (b) the Project Operational Manual shall be issued by thePCU and in place (as described in Section C.2., page 15).

4.3 Procurement issues:

The procurement function will be undertaken by the PCU. The PCU will be responsible for: (i)preparing tender documents, (ii) calling for bids , (iii) evaluating and comparing bids and consultantsqualifications, (iv) awarding contracts, (v) signing the contracts, and (vi) maintaining all the correspondingrecords. Contracts are expected to be small; therefore procurement methods identified are simple and thereare no special issues to be addressed. A Bank Procurement Specialist has carried out a CapacityAssessment to Implement Procurement and verified the capacity of the PCU to carry out procurement inagreement with Bank standards and requirements. NAFIN's Unidad de Financiamientos Especiales,which has significant experience with Bank procurement and detailed technical training from Bankprograms in Turin and Washington, D.C., will support all procurement conducted by the PCU.

It was agreed at Negotiations that, in order to facilitate the large number of small transactionsinvolved in the Microfmance Services Component (for subloans for eligible Investment Subprojects), aprocurement category of commercial practices will be used, in accordance with procedures acceptable tothe Bank. There will be no prior review of Subloans.

The overall risk assessment is considered to be average. The risk assessment is low for thefollowing sections: (i) legal aspects, (ii) project cycle management, and (iii) record keeping. The risk levelhas been determined to be average for the following sections of the assessment: (i) organization andfunctions (pending completion of the operational manual), (ii) support and control systems, (iii) generalprocurement environment, and (iv) private sector assessment. The PCU has already prepared anacceptable Procurement Plan for the project. (Detailed information is presented in Section C (ProjectDescription Summary, Section 2) and in Annex 6).

4.4 Financial management issues:

Financial Management. In order to be in compliance with Bank requirements per OP/BP 10.02,an assessment of the Project's financial management system was carried out by an accredited FinancialManagement Specialist. The assessment covered the Project's financial management system, whichincludes budgeting, accounting, intemal control, auditing and reporting. Project staffing was reviewed aswell. The assessment was based on applicable Bank guidelines, which included the Project FinancialManagement Manual (World Bank, February 1999), The Loan Administration Change Initiative LACI,Implementation Handbook (World Bank, September 1998), the Financial Accounting, Reporting andAuditing Handbook or FARAH (World Bank, January 1995) and the Guidelines and Terms of Referencefor Audits of Projects with Financing by the World Bank in the Latin America and Caribbean Region(World Bank, May 1999).

Given that the PCU will be responsible of overall coordination of project planning, operation,resource management, evaluation, supervision resource management, evaluation of program operation andreporting, it is taking actions to include in the management information system (MIS System) a module toproduce quarterly Project Management Reports (PMRs) which eventually will be used for projectdisbursement. Traditional disbursement methods such as statements of expenditures (SOE), direct

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payments and special commitments would be used until the PCU is ready to adopt the PMR-baseddisbursement methodology, and until full compliance of the Bank's requirements. These arrangements andresulting procedures will be reflected in the Operational Manual.

A time-bound action plan satisfactory to the Bank was agreed to at Negotiations so that the PCUwill prepare and issue quarterly PMRs not later than July 31, 2002. These PMRs will include sources andapplications of funds for the Project, both cumulatively and for the period covered in the report, withspecial attention to expenditures financed by the Bank loan. The PMR will describe physical progress inProject implementation and explain variances between plans and actual performance. The PMRs will beprovided within 45 days of the completion of each three-month period.

Budgeting Process. An annual budget will be prepared by the PCU on the basis of annualactivities for each component. Financing for the proposed project would be included in the NAFIN budget,and funds would be channeled through a Special Account. Counterpart funds for the Project would flowfrom NAFIN's Treasury to an account established for project purposes. For each participatingSoutheastern State, funds would be deposited into a commercial bank account established by each state forproject purposes. This bank account will be complemented by deposits of counterpart funds. The PCU willbe responsible for budget consolidation and project control and reporting.

Cost of Funds. Project funds for the Microfinance Services Component will be borrowed byNAFIN under the terms of an authorization issued by the Secretaria de Hacienda y Credito Ptiblico.NAFIN will on-lend the funds to Eligible Microfmance Institutions that fulfill the Project eligibility criteriain accordance with the Operational manual. The interest rate that NAFIN will lend to eligible MFIs willvary according to the currency of the Intermediary Loan (Type A), with (i) peso-denominated loans basedon the financial intermnediary market interest (TIIE) and a margin established in the Operational manual and(ii) dollar-denominated Intermediary Loans (Type A) based on the interest rate detailed in the Operationalmanual. The eligible MFIs, in turn, will fund subloans for eligible investment subprojects to eligiblesub-borrowers at a rate of interest sufficient to cover all operating and financial costs. During the life ofthe Project, the cost of funds from the PCU to the