Impediments to Fiscal Adjustment

After the 1982 debt crisis, the authorities’ ability to reduce the size of the PSBR was hampered by numerous and inefficient public sector enterprises, structural impediments to adjusting public sector revenue and expenditure, and the adverse impact of the sizable domestic debt in relation to GDP that existed at the beginning of this period.

The number of public sector enterprises had increased significantly during the 1970s and reached over 1,100 by 1982, with the overall deficit of these enterprises accounting for about one fourth of the public sector’s borrowing requirements. The growing deficit of the public sector enterprises, which was financed mainly by transfers from the federal budget, reflected a sharp rise in public sector investment, non-market-related pricing policy, and increasing inefficiency. By the end of 1982, the authorities had determined that the size of the public sector affected adversely both economic productivity and efficiency; moreover, it affected the ability to adjust quickly fiscal policy to meet economic objectives.

Impediments to increasing public sector revenue hampered fiscal adjustment efforts, with additional public sector revenue contributing only 1½ percentage points to the 10 percentage points of adjustment in the primary balance during 1982–87 (see Table 2). A dominant factor behind the poor revenue performance was a large decline in revenue from oil exports, with sales falling from over 8 percent of GDP in 1982 to an average of under 5 percent of GDP in 1986–88. This deterioration was partly offset by increased proceeds from the domestic sale of petroleum, reflecting adjustments in domestic prices to international levels. Another reason for the lack-luster revenue performance was the narrow tax base, high marginal income tax rates, and, for taxes collected with a lag, the negative effects of higher inflation on revenue collections in real terms.

The inertial element of fiscal imbalances that resulted from the link between debt, inflation, and interest rates also impeded fiscal adjustment during this period. In 1982, the total stock of domestic debt was already equivalent to 25 percent of GDP, while the average annual cost of debt financing was 20 percent.¹¹ As a result, interest payments on domestic debt were equivalent to almost 5 percent of GDP, accounting for over one third of the borrowing requirement of the public sector. Despite the sizable fiscal effort at the level of the primary balance during 1982–87, the average overall public sector deficit during the period was equivalent to 13 percent of GDP. Reflecting a heavy reliance on the issue of money to finance the fiscal deficit during this period, total domestic debt declined to under 17 percent of GDP by the end of 1987. However, with the average cost of funds rising to over 90 percent, interest payments on domestic debt rose to over 16 percent of GDP. As a result, by 1987 a significantly larger fiscal effort at the level of the primary balance was required to maintain an unchanged borrowing requirement of the public sector.¹²

Road to Fiscal Adjustment

During 1982–87 the reduction of public sector non-interest expenditure was equivalent to almost 10 percentage points of GDP (see Table 2). This was accomplished by equivalent sizable reductions in non-interest current and capital expenditure, with the decline in capital expenditure shared between the Federal Government and the public enterprises. However, the cuts in current expenditure hurt the Government’s ability to meet certain social needs and maintain current services, while the reduced public investment caused infrastructural bottlenecks. The adverse effect of the cuts in expenditure may have been compounded by their impact on economic activity, which in turn would then have adversely affected the capacity of the Government to raise revenues.

In their efforts to reform the public sector, the authorities placed emphasis on the divestiture of public sector enterprises. The number of state-owned entities was cut from over 1,100 in 1982 to 420 by the end of 1988 through a process of mergers, liquidations, and sales. Since the end of 1988, the effort to streamline the public sector has continued with the number of state-owned entities estimated at less than 250 by the end of 1991; moreover, the recent divestitures have included some of the largest enterprises in the country, including two air-lines, a truck manufacturing company, two steel companies, and the Cooper Mining Company. More recently, the large telecommunications company and the commercial banks were privatized. This policy has allowed the public sector to concentrate its limited resources on priority sectors and has allowed the private sector to participate in the development of critical areas of the economy.

On the revenue side, in 1987, the authorities implemented a major reform of the tax system to correct distortions (especially the effects of inflation) and to enhance Mexico’s external competitiveness by harmonizing the domestic tax system with those abroad. The reform was accelerated in 1989–90 by widening the tax base and reducing marginal tax rates. In particular, the Government introduced a new minimum tax of 2 percent on firms’ assets; abolished tax exemptions granted to certain sectors of the economy; reduced the corporate tax rate from about 40 percent to 36 percent, while changing the system of taxing corporate dividends to discourage tax evasion and encourage reinvestment of profits; and lowered the tax rate on the highest personal income bracket to 35 percent.

In response to government policies, including an increase in the fiscal primary surplus from 4.7 percent of GDP in 1987 to 7.9 percent of GDP in 1989, the rate of inflation and nominal interest rates declined in both 1988 and 1989; moreover, private sector confidence began to recover as evidenced by a decline in 1989 of real interest rates in association with a net inflow of private capital. As a result, in 1989 both the PSBR and the operational deficit declined. Domestic debt, however, rose to almost 24 percent of GDP, reflecting the authorities’ determination to avoid central bank financing of the PSBR. In 1990, the improvement in the fiscal balances continued with the primary surplus remaining at 7.9 percent of GDP and the PSBR declining to 3½ percent (the lowest PSBR in ten years). In addition, the operational balance moved to surplus, resulting in a slight decline in the real level of domestic debt.

In 1991, the process was reinforced with declines in inflation, nominal and real interest rates, and the level of domestic debt. Domestic interest payments declined to 3½ percent of GDP (compared with 6.9 percent of GDP in 1990 and 13 percent of GDP in 1988), reflecting lower interest rates (an average of around 20 percent in 1991 compared with 35 percent in 1990), and a lower level of domestic debt (estimated to have declined by over 4 percentage points of GDP to 19 percent of GDP). The PSBR (excluding revenues from privatization) declined to 1.5 percent of GDP, while the operational surplus increased to over 2.3 percent of GDP. This was consistent with a decline in the fiscal effort at the level of the primary balance and allowed for some increase in public sector investment and current expenditure.¹³

Wage-Price Pact

As part of the wage-price pact of December 1987, the minimum wage, the controlled exchange rate, and public sector prices and tariffs were, after an initial adjustment, frozen throughout 1988.¹⁴ A new pact of economic growth and stability (PECE) was announced in December 1988. Minimum wages and public sector prices and tariffs were adjusted while the peso was made subject to a daily preannounced schedule of depreciation against the U.S. dollar. The authorities have extended the PECE at unannounced, although fairly regular, intervals. The nominal rate of adjustments to minimum wages has declined with inflation; adjustment to public sector prices and tariffs has met microeconomic objectives; and the preannounced crawl of the peso has decreased steadily.¹⁵

In combination with tight financial policies, the wage-price pact has aided in reducing inflation. “A major component of inflation in many countries stems from what may be called the imposition of an external diseconomy by each firm and household acting in isolation as it seeks to protect itself against inflation.”¹⁶ Hence, even in the absence of pervasive indexation, inertial inflation may exist, which is costly to eliminate by using financial policies alone. The use of an incomes policy, in combination with tight financial policies, can reduce this inertial element and the degree of monetary and fiscal restraint needed to achieve lower inflation. In turn, the costs of adjustment are reduced.

Program of National Solidarity

The second element of the Government’s incomes policy has been the “Program of National Solidarity,” or “Pronasol.” This program was initiated in 1989 with the purpose of eradicating extreme poverty and integrating the poor into the process of economic stability and recovery, with an emphasis on specific programs rather than broad and costly subsidies. Pronasol seeks to expand and strengthen programs in education, nutrition, and health, as well as those related to the provision of drinking water, sewage, and electricity. The program is decentralized, with the Government acting closely with individual communities.

The amount of government resources targeted for programs within Pronasol has increased significantly since its inception. Social expenditure totaled 36 percent of total noninterest expenditure in 1989, of which 2.1 percent was within Pronasol. Social expenditure increased to 38 percent of total noninterest expenditure (2.6 percent within Pronasol) in 1990, 46 percent of total noninterest expenditure in 1991 (3.5 percent within Pronasol), and the 1992 budget programmed social expenditure at 51 percent of total noninterest expenditure (4 percent within Pronasol). With noninterest expenditure increasing somewhat in real terms as interest payments declined, social expenditure has increased in real terms by 16 percent in 1990 and an equivalent increase is estimated in 1991. This increased social expenditure, as well as its careful management, has helped improve social equity while Mexico undergoes its economic stabilization program.

International Trade and Investment Liberalization

Mexico has liberalized its international trade and investment regimes in stages. In 1985, Mexico began dismantling its tariff and nontariff trade barriers and joined the General Agreement on Tariffs and Trade (GATT) in August 1986.¹⁷ Import substitution policies and reliance on oil exports for foreign exchange earnings were replaced with policies aimed at attracting foreign investment, lowering trade barriers, and generally making the country more competitive for non-oil exports. In 1989, foreign investment regulations were also liberalized. The new regulations simplified the procedures for authorizing investment projects, relaxed limits on foreign ownership, and reduced some barriers to entry by foreigners into the Mexican stock market.

The implications of this transformation into a highly open economy have been significant as the incentive structure has been reoriented while major distortions have been removed, leading to greater efficiency. Export growth has picked up, and exports have been diversified. Moreover, the economy’s productive base is being modernized as a result of the access to imports at international prices and greater amounts of foreign direct investment. Mexico is currently involved in the negotiation of four free trade agreements, one with the United States and Canada and three with Latin American countries.

Until the late 1980s, despite a period of gradual transformation and liberalization, the financial system in Mexico was characterized by interest rate restrictions, domestic credit controls, high reserve requirements, and fragmented financial markets causing inefficiencies in the intermediation between borrowers and lenders.¹⁸ Capital markets were not well developed, and firms often had to turn to informal markets. Moreover, the shallowness of the bond market and the existence of informal credit markets hampered the conduct of monetary policy by restricting the scope for open market operations and limiting the ability of the Bank of Mexico to monitor overall credit market conditions.

In 1988, the Mexican Government accelerated the process of financial reform. The objectives were to enhance efficiency through greater reliance on market forces, to promote the growth and deepening of financial markets, and to improve the effectiveness of monetary policy. In addition, the reforms sought to improve the capitalization of Mexican financial institutions with a view to preparing them for international competition.

Key liberalization measures included the freeing of interest rates and the elimination of direct controls on credit. In November 1988, quantitative restrictions on the issuance of bankers’ acceptances were lifted, and banks were allowed to invest freely from these resources. In April 1989, major reforms were introduced that eliminated controls on interest rates and maturities on all traditional bank instruments and deposits, as well as remaining restrictions on bank lending to the private sector. But the cornerstone of the institutional reform was the reprivatization of Mexico’s commercial banks, announced in 1990, and subsequently successfully implemented, which was part of a wider plan to promote financial integration through a universal banking system.

Deregulation of Economic Activities

Complementing the measures mentioned above, steps have been taken to deregulate specific sectors, particularly in the areas of transportation, communication, petrochemicals, fisheries, and most recently agriculture. These measures are enabling market forces in Mexico and abroad to take advantage of available opportunities. Most recently, an agricultural reform bill was introduced in Congress that would allow the owners of agricultural land to rent or sell their land, while putting an end to the distribution of land that has been in place since the rural reform in 1917. This change should allow for a substantial increase in agricultural productivity.

In the context of the authorities’ exchange rate and incomes policy, the structure of the balance of payments has changed dramatically in recent years. During much of the 1980s, improvements in the fiscal operational balance were related directly to improvements in the external current account balance. Since 1989, the current account balance has been linked directly to movements in private capital flows, with increased net private inflows resulting in growing private sector imports of intermediate and capital goods. The strong fiscal outcome during this period has strongly influenced the willingness of the private sector to make use of foreign savings for investment in Mexico and has been associated with rising current account deficits.