III An Analysis of the Linkages of Macroeconomic Policies in Mexico

Abstract

This section examines the interrelationship between fiscal, monetary, and exchange rate policies in Mexico from the late 1970s to mid-1991. The main purpose is to evaluate critically the consistency of the macro-economic policies that were undertaken by Mexico after the emergence of the debt crisis in 1982 and to analyze some key policy issues that arose during subsequent stabilization efforts.

This section examines the interrelationship between fiscal, monetary, and exchange rate policies in Mexico from the late 1970s to mid-1991. The main purpose is to evaluate critically the consistency of the macro-economic policies that were undertaken by Mexico after the emergence of the debt crisis in 1982 and to analyze some key policy issues that arose during subsequent stabilization efforts.

The most recent Mexican stabilization program, which started at the end of 1987, has resulted in a sharp decline of inflation and in renewed growth. While Mexico’s economic achievements are substantial, it is important to recognize that attempts at economic stabilization started in 1983 and that during the period 1983–88 the Mexican economy experienced the lowest rate of growth of economic activity since the early 1950s. This recognition provides the motivation for this section, which examines a key policy issue faced by the Mexican authorities in their stabilization efforts, namely, the linkages between economic policies and the authorities’ objectives of price stability and sustainable economic growth. Indeed, while Mexico experienced an average surplus in the primary fiscal balance—defined as the overall cash balance of the public sector exclusive of total interest payments and exchange losses—of 4 percent during the period 1983–87, the average annual inflation rate during the same period was 89 percent. Why did the fiscal effort during the period 1983–87 not produce a substantial reduction in inflation? What was the role of domestic monetary policy and the exchange rate and of the increasing issuance of domestic public debt? What policy changes may have accounted for the reduction of inflation and the recovery of output growth since 1989?

To help answer these questions, this section analyzes the sustainability of domestic policies using a simple framework based on the government budget constraint. The purpose of the exercise is first, to provide an indicator of the long-run inflation rate consistent with the fiscal and monetary policies that were implemented and second, to provide an explanation of the divergence between the observed and the long-run inflation rates. A major finding is that since 1982 the interaction between economic policies and the perceptions of economic agents about the sustainability of those policies was at the core of explaining the dynamics of key macroeconomic variables.

During their stabilization efforts, the authorities also confronted two additional and related issues: the persistence of high real interest rates and the volatility of capital flight. A major problem faced by the authorities since 1982 was that adverse expectations regarding the future course of economic policy or adverse exogenous shocks to the Mexican economy (such as increases in international interest rates or declines in the price of oil) resulted in substantial capital flight and loss of foreign reserves. This section explores the factors underlying the persistence of high real interest rates and identifies causes and problems associated with capital flight.

Three periods are considered: (a) the pre-debt crisis period characterized by expansionary fiscal and monetary policies that were accompanied by both an inflow of foreign loans to the public sector and a flight of private capital; (b) the period 1983–87, when serious attempts were undertaken to correct domestic economic imbalances to deal with the high inflation and a stagnant economy; and (c) the period 1988–91 that was characterized by a substantial improvement in economic conditions.

The rest of the section is organized as follows: The first part derives a proxy for the long-run rates of inflation consistent with the domestic policies that were implemented in the Mexican economy during the period 1978–90. In the second, third, and fourth parts is an analysis of the divergence of the observed inflation rates from the estimated long-run rates that corresponds to the three periods under study. An attempt is made throughout to highlight central policy issues and lessons derived from the Mexican experience. The last part summarizes major findings.

Fiscal Deficits and Long-Run Equilibrium Rates of Inflation

A salient feature regarding fiscal policy in Mexico has been the evolution of the primary fiscal balance, which shifted from an average deficit of more than 5 percent of GDP during 1978–82 to a surplus averaging 4 percent during 1983–87 and more than 7 percent of GDP during 1988–90. In this context, a major policy issue is the extent to which the evolution of the fiscal position has influenced inflation in Mexico as well as the sustainability of the adjustment effort. This section attempts to deal with this issue using a simple framework based on the government budget constraint to provide an indicator of the inflation rate that would prevail in the long run given the observed primary fiscal balance.1

The exercise is based on the following definition of the government budget constraint.

-primt+it-1ddt-1+fdt-1i*t-1=Δmt+Δddt+Δfdt.(1)

prim = primary balance as a proportion of GDP, with the primary balance defined as public sector receipts less expenditures (exclusive of total interest payments and exchange losses).2

dd = t - 1 domestic government debt in period t - 1 as a proportion of GDP in period t,

fdt - 1 = foreign public debt (expressed in Mexican pesos) in period t - 1 as a proportion of GDP in period t,

m = central bank credit to the Government as a proportion of GDP,

i = the domestic interest rate on government bonds,

i* = interest rate on foreign borrowing,

and for any variable X, x = X/GDP and Δ xt = (XtXt - 1)/GDPt.

At every period of time, any fiscal deficit needs to be financed either by increases in the credit of the domestic financial sector to the Government or by new issues of government debt outside the domestic financial sector.

In the context of the budget constraint, the following question can be asked: ceteris paribus, what is the inflationary tax rate needed in the long run to finance the observed primary balance? A simple answer is to characterize a long-run equilibrium as one in which economic agents achieve their desired long-run holdings of money and bonds relative to GDP and are able to keep those ratios invariant over time.3 Alternative values of the primary balance, hence, have corresponding values of the proxy for the long-run inflation rate.

Since an additional feature of long-run equilibrium is that the actual rate of inflation equals the expected inflation rate, the nominal interest rate can be approximated as: i = r + π, where r is the real rate of interest and π is the inflation rate.

Denoting π as the rate of growth of real output, the long-run version of equation (1) is4

-prim+rdd+i*fd=Δfd+m(π+ρ)+dd(ρ)(2)

where

-prim + r dd + i * fd corresponds to the operational fiscal deficit, (def) that is, the overall fiscal deficit corrected for the amortization of domestic public debt owing to inflation.

Equation (2) can be solved for the rate of inflation that, ceteris paribus, would be needed in the long run to finance the fiscal deficit.5 However, for equation (2) to be a strict representation of the long run, it would be necessary to model the markets for money and bonds in order to estimate the desired holdings of real money and bonds in the long run. In this section, a more simplified procedure is followed by using the actual ratios ddt and mt in the estimation of the long-run inflation rate. This restriction implies that the estimated long-run inflation rate derived from equation (2) should only be taken as a proxy for the long-run rate.6

Before proceeding with the estimation of such a proxy for the long-run inflation rate, it may be useful to note that equation (2) gives no explicit independent role to the exchange rate. Indeed, given the rate of foreign inflation, equation (2) could also be used to solve for the rate of exchange rate depreciation consistent with the fiscal deficit in the long run, if the following long-run equilibrium condition were to hold:

π=ê+π*,(3)

where

e^ is the rate of change of the exchange rate and π* is the rate of foreign inflation.

The Real Interest Rate

A problem encountered in estimating equation (2) is deciding on the appropriate value of the real interest rate.7 Table 3 presents estimates of the fiscal deficit (def) based on the ex ante real interest rates on three-month treasury bills in Mexico during the period 1978–90. The series for the expected inflation rate used to estimate the ex ante real interest rates is presented in Appendix I.

Table 3.

Fiscal Deficits and Real Interest Rates

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Sources: Appendix I, Bank of Mexico, Indicadadores Economicos; and Fund staff estimates.

A negative number indicates a fiscal surplus. Adjusted for the financing requirements associated with financial intermediation and statistical discrepancy.

The most important features of Table 3 are as follows: (a) The operational deficit based on an ex ante real interest rate (def) was negative only in 1990, while the primary balance showed a continuous surplus from 1983. (b) During 1978–81—the pre-debt crisis period—the estimated values for the expected inflation rates surpassed the actual inflation rates, resulting in ex ante real interest rates that were lower than the ex post rates. The opposite pattern is observed during 1984–87. (c) During the first two years of the recent Mexican adjustment program, 1988 and 1989, the ex ante real interest rate was lower than the ex post rate, reflecting expectations about the inflation rate greater than the observed inflation. During that period, both the ex ante and the ex post real interest rates remained very high. As the stabilization efforts were consolidated in 1990, real interest rates declined sharply.

Rate of Inflation in Long-Run Equilibrium

Based on equation (2), Table 4 presents a proxy for the long-run inflation rate given the fiscal position and the behavior of output growth, real holdings of bonds and money, and the availability of external financing. This simple framework cannot be interpreted as a model of inflation since most of the variables involved are endogenous. A detailed explanation of the derivation of the longrun inflationary tax rate as well as the underlying assumptions are contained in Appendix II.

Table 4.

Inflation Rates

(Average of the year)

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Sources: Table 3; Bank of Mexico; Indicadores Economicos; and Fund staff estimates.

Table 4 shows the evolution of the divergence between the actual inflation rate and the proxy for the long-run inflation rate. The salient features of these estimates, which will provide the background for the analysis in the next sections are as follows: (1) During the period 1978–82, the estimated proxy for the long-run inflation rate exceeded the observed inflation rate; the divergence became very large in 1981–82. (2) Adjustment efforts undertaken to correct fiscal imbalances during 1983–84 resulted in a sharp decline in the proxy for the long-run inflation rate, which in fact dropped below the observed inflation rate. (3) This pattern was reversed during 1985–86, when the fiscal stance deteriorated reflecting, partly, two adverse shocks faced by the Mexican economy, namely, the earthquake that struck Mexico City in 1985 and the sharp decline in oil prices in 1986. (4) Consistent with a strong fiscal effort in 1987, the proxy for the long-run inflationary tax rate declined significantly. However, owing to factors discussed below—including rigidities in the wage salary structure—the observed rate of inflation remained very high. (5) Since the implementation of the recent economic stabilization program in 1988, which involved further adjustments in the fiscal stance combined with structural reforms and the adoption of an incomes policy, both the long-run and the observed inflation rates declined significantly. However, as will be shown below, economic agents’ concerns about the permanence of the economic policies during 1988–89 may have resulted in an observed inflation rate that was higher than the one that was consistent with the fiscal stance in the long run. Moreover, the negative value obtained for the proxy for the long-run inflation tax rate during 1990 indicates that the fiscal stance not only ceased to require the inflationary tax as a source of finance, but even exerted deflationary pressures on the economy.

The next three sections analyze the three most recent subperiods and attempt to provide an explanation for the divergence between the observed inflation rate and the proxy for the long-run rate.

Unsustainable Public Sector Deficits and Balance of Payments Crisis, 1978–82

The evolution of the public sector deficit and the sources of financing during 1978–90 are shown in Table 5. During the period 1978–82, the overall public sector deficit as a proportion of GDP tripled. While credit from the central bank was the main source of finance in 1978, foreign loans became the most important contributor to the financing of the government deficit by 1981. As shown in Table 4, the inflation rate averaged 22 percent during the period 1978–81.8

Table 5.

Public Sector Deficit and Its Financing

(As percentage of GDP)

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Sources: Secretariat of Finance of Public Credit; and Fund staff estimates.

A positive number means a surplus.

While the availability of external loans allowed the Government to finance the deficit without a substantial increase in the inflation rate during the period 1978–81, the situation was not sustainable. Consider equation (2) once more. An increase in the primary deficit largely financed by foreign debt produces a bigger rise in the left-hand side of equation (2) than in the right-hand side, owing to the interest payments on the increased debt. For the budget constraint to be satisfied, an additional variable in equation (2) needs to adjust.9 In the context of this simple framework, an increased fiscal deficit would be consistent with an unchanged rate of inflation in the long run only if any of the following conditions (or a combination of them) holds: (1) there is a sustainable increase in output growth that would provide for sufficient resources to service the external debt, (2) there is a further and sustainable inflow of foreign funds, and (3) there is an increase in the desired holdings of domestic real money.

None of these conditions held in the Mexican economy. Appendix II discusses the reasons that prevented conditions (1) and (2) from holding. In essence, a large proportion of government investment—in particular, by the government-owned state enterprises—that was undertaken during the period 1978—81 did not contribute to the long-run productive capacity of the economy.10 Finally, as evidenced by the large amounts of capital flight and the resulting balance of payments crisis of 1982 (to be discussed below), condition (3) also did not hold. Specifically, real holdings of money (as measured by currency in circulation plus demand deposits denominated in domestic money) declined by 15 percent during 1982.11

The discussion above serves to explain how the persistence of large fiscal deficits in the Mexican economy during the period 1978–81 exerted substantial inflationary pressures on the economy, even when they were not fully financed by monetary expansion and the economy was experiencing a short-run expansion in output. As domestic residents’ perceptions about the unsustainability of the nonmonetary sources of finance increased, they moved away from domestic money in the expectation that the Government would need to rely increasingly on the inflationary tax as a source of financing the rising fiscal deficits. As a result, in every year during the period 1978–81 the estimated proxy for the inflationary tax rate needed to finance the fiscal deficit in the long run surpassed the observed inflation rate (see Table 4). The discrepancy between the two rates reached a maximum in 1981 when the largest primary deficit experienced during the period was registered (see Table 3). As the demand for real money declined, capital flight accelerated and the speed of new foreign lending to Mexico declined in 1982, the share of credit from the central bank in the financing of the overall fiscal deficit (17.8 percent of GDP) increased substantially from 29 percent (in 1981) to 42 percent (in 1982). Inflation increased sharply and the economy experienced a balance of payments crisis that ended with a large depreciation of the Mexican peso.

Indeed, the same analysis can be used to show how the exchange rate policy undertaken by the authorities also was not sustainable, using equation (3) to obtain a proxy for the depreciation of the exchange rate that would have been consistent with the fiscal deficit in the long run. Table 6 shows that during 1978–81 the exchange rate policy followed by the authorities was inconsistent with the expansionary fiscal policy that was being pursued. It also shows how the discrepancy between the proxy for the long-run depreciation of the Mexican peso and the actual depreciation increased continuously during the period. The perception that the exchange rate system had to be abandoned if large fiscal deficits were to continue was also reflected in the evolution of the forward exchange rate. As shown in the third column of Table 7, the premium in the forward market for the Mexican peso also increased continuously during the period. This suggests that economic agents’ perceptions about the sustainability of the exchange rate regime sharply deteriorated as inflationary pressures mounted in the Mexican economy.

Table 6.

Depreciation of the Exchange Rate Consistent with Fiscal Deficit

(In percent)

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Source: Table 4; International Monetary Fund, International Financial Statistics, various issues; Chicago Mercantile Exchange, International Money Market Yearbook, various issues; and Fund staff estimates.

The premium is defined as the ratio of the 30-days’ forward exchange rate to the spot exchange rate. Data correspond to the average premium for the year.

Table 7.

External Debt and Resource Transfer as Financing Components of Capital Flight

(In billions of U.S. dollars)

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Sources: Gurria and Fadl (1991), p. 6.

Defined as net exports of goods and nonfactor services.

It is estimated that the flight of capital increased sharply during 1981 and 1982 (Table 7).12 This shift away from the Mexican peso and into foreign accounts exerted great pressure in the stock of foreign reserves, which declined by $6 billion in 1982, after recording an average increase of $1 billion a year from 1978 to 1981. During 1978–81, capital flight was more than offset by the increasingly large inflows of foreign loans. As a result, international reserves expanded and the resource balance—net exports of goods and nonfactor services—was negative. As the proceeds from exports and other external inflows were still used to finance imports, the impact of capital flight on growth was not perceived as severe. The situation changed drastically in 1982, when Mexico faced a sharp reduction in its access to external credit. Greater capital flight had to be financed through reduction in international reserves and a contraction in net imports, which impinged negatively on economic growth. Facing the pressures on international reserves exerted by the large amounts of capital flight, the authorities implemented two large devaluations of the mexican peso during 1982.13

Fiscal Adjustment, Domestic Debt, and the Persistence of Inflation, 1983–87

In contrast with developments during 1978–82, there was a marked fiscal adjustment at the level of the primary balance in the period 1983–87.14 In spite of these efforts, the inflation rate averaged 89 percent during this period and peaked during 1987 at 160 percent. In addition, with the exception of a temporary recovery in 1984, economic activity remained weak and, on average, real GDP contracted by 0.2 percent a year during the period. This section examines the factors that may have contributed to the persistence of inflation and the extent to which the fiscal adjustment undertaken during the period was insufficient to achieve the Government’s stabilization goals.

Shift from Foreign to Domestic Debt, 1983–84

In December 1982, Mexico embarked on a stabilization program to reduce inflation and improve balance of payments conditions by reducing the public sector deficit and the monetary expansion of the central bank.

In the context of sharply reduced access to international capital markets, fiscal deficits were financed increasingly by the sale of government bonds to the banking system and the public.15 This form of financing resulted in a sharp increase in real rates of interest. As shown in Table 3, real interest rates on treasury bills, measured on either an ex ante or an ex post basis, moved from being highly negative in 1982 to being positive in 1983–84.

It is estimated that capital flight continued during 1983, albeit at a lower rate than in 1982 (see Table 7). The continuation of capital flight in the context of severely reduced access to international capital markets implies that the buildup of international reserves that Mexico achieved during 1983–84 was only possible through substantial transfers of real resources, which imposed an important constraint on growth.

Although the stabilization efforts reduced the inflation rate during 1983 and 1984, inflation remained high and above the proxy for the estimated rate that would be sustainable if the surplus in the primary balance were to be maintained (see Table 4). Consider equation (2) once more. As Table 4 indicates, the fiscal efforts during 1983–84 led to a substantial reduction of the left-hand side of equation (2). The exercise conducted earlier suggests that the fiscal policy may have been consistent in the long run with a significant reduction of inflation even in the context of sharply reduced access to foreign financing. In the short run, however, the crowding out of private investment arising from the need to finance public deficits with domestic debt and the substantial transfer of real resources exacerbated the slowdown of economic activity and the persistence of inflation. Had the fiscal efforts continued, increased confidence in the program might have improved, which would have then translated into an increased demand for domestic real money (a further reduction in capital flight) and a decline in inflationary pressure.

Part of this convergence toward a lower rate of inflation actually occurred in 1984. As the primary surplus continued to increase during that year (relative to GDP), economic activity recovered and inflation declined. Consistent with these developments, capital flight decreased significantly in 1984.

Adverse Shocks and Renewal of Inflationary Pressures, 1985–86

As previously described, pressures on the fiscal stance including those arising from significant fiscal rigidities, were clearly evident during 1985–86.16 The weakening of the fiscal position renewed the inflationary pressures in the economy and caused the estimated proxy for the long-run inflationary tax rate to exceed the observed rate of inflation during 1985–86 (see Table 4). As the fiscal stance deteriorated, the Government needed to rely increasingly on the issuance of domestic debt as a source of finance. Indeed, the stock of public sector domestic debt—excluding debt held by the central bank—increased from 3 percent of GDP at the end of 1984 to 5.4 percent at the end of 1986. Higher real interest rates, crowding out of domestic private investment, and further financial disintermediation (as evidenced by a decline in real money balances), followed. Indeed, as indicated in Table 3, real interest rates (on an ex ante basis) may have exceeded 20 percent by 1986.

In examining equation (2) once more, we find that the decline in economic activity and in real money balances, as well as rising real interest rates, implies that in the steady state the inflationary tax rate would have to accelerate even further to finance the overall fiscal sector deficit. An important lesson from these developments is that increasing fiscal deficits are inflationary in the long run because there is a limit to the sales of public sector bonds to the private sector. As this limit is approached, the persistence of fiscal deficits requires the inflationary tax as a financing source.

Wage Indexation and Persistence of Inflation, 1987

A new economic program, initiated in 1987, focused on improving the fiscal stance and maintaining monetary discipline. During 1987, the primary surplus reached 5 percent of GDP and credit from the central bank to the Government constituted only 3 percent of the financing of the public accounts. However, as in the previous attempts to achieve a sustainable reduction of inflation and a recovery in economic activity, the strong reliance of the public sector on domestic debt and its effects on real interest rates constituted an important constraint in achieving the desired targets.

While many similarities existed between the adjustment efforts in 1983–84 and those implemented in 1987, there were two important differences. First, by 1987, the real stock of public sector domestic debt held by the private sector was significantly higher than at the end of 1984, which increased the perceived risks involved in holding domestic assets. As a result, real interest rates (on an ex ante basis) remained high in spite of the fiscal adjustment (see Table 3). Second, while minimum wages were adjusted twice a year in 1984, they were adjusted five times in 1987, introducing a de facto wage-indexation scheme that contributed to the persistence of inflation. As a result, the observed rate of inflation was significantly higher than the proxy for the long-run rate in 1987 (see Table 4). As is well known, however, wage indexation may sustain the inflationary process for a longer time than in the absence of indexation, but it can not produce a steady-state inflation rate different from the one that would result from a non-indexed process, unless an increase in monetary expansion were to validate the increases in nominal wages. In the absence of such a monetary expansion, the inflation rate would decline in the long run. In the process, a reduction in the rate of increase in wages associated with the decline in inflation constitutes an additional factor contributing to the achievement of lower inflation.

The policy response to these considerations was the introduction in December 1987 of a comprehensive program in which orthodox fiscal and monetary policies were complemented by a freeze in wages and prices, and the pegging of the exchange rate in the context of a social pact between labor, business, and the Government.

Dynamics of a Successful Stabilization Program, 1988–91

The main features of the economic program initiated in December 1987 are discussed in detail in Section II.17 By 1991, Mexico’s achievements were impressive; inflation is estimated to have declined to 19 percent by the end of 1991; real GDP grew by an estimated 4 percent; and the overall balance of payments registered a surplus of $5 billion in the first ten months of 1991. These achievements, which some observers have called the “Mexican miracle,” were not obtained, however, without difficulties. This section focuses on two crucial and related problems that the Mexican authorities faced in achieving and consolidating their stabilization efforts: (1) the initial concerns of economic agents about the maintenance of the economic program, in general, and in the announced exchange rate policy in particular, and (2) the persistence of high real interest rates, which raised doubts about the sustainability of the adjustment effort.

The Credibility Problem

The incomes policy undertaken under the December 1987 program broke the process of wage indexation, and as such the inflation rate declined from 160 percent during 1987 to 52 percent during 1988. In spite of this progress, concerns about the sustainability of the economic program remained, in particular, with respect to the Government’s ability to maintain the announced fixed exchange rate policy.

An indication of such concerns with regard to the exchange rate policy can be obtained by comparing the actual depreciation of the currency with a measure of the expected depreciation of the exchange rate as represented by the interest rate differential between a peso denominated Mexican treasury bill (Cetes) and a dollardenominated Mexican treasury bill (Pagafes).18 The evidence shown in Chart 4 suggests that expectations of the future spot exchange rate consistently overestimated the actual future rate, indicating lack of full credibility in the exchange rate policy. This differential was greatest during 1988 when, with the exception of a small change in February, the exchange rate was pegged to the U.S. dollar.

Chart 4.
Chart 4.

Interest Rate Differentials Versus Exchange Rate Depreciation

(In percent a month)

Note: Cetes = peso-denominated Mexican treasury bills; Pagafes = dollar-denominated Mexican treasury bills.

The most serious effect of these concerns about the sustainability of the exchange rate policy was on the external position. In the context of an acceleration of the trade reform, expectations of a future devaluation resulted in a sharp increase in private sector imports, a deterioration of the current account, and—given the lack of access to international capital markets and the amortization and interest payments on the large outstanding stock of external debt—a loss in international reserves of $6.8 billion during 1988.

An additional problem was that, in the context of the structural reforms that included the liberalization of financial markets, interest rate parity implied high domestic interest rates. To the extent that the incomes policy was successful, at least partially, in reducing inflationary expectations, the increase in nominal interest rates also involved an increase in real interest rates. As shown in Table 3, on an ex ante basis, real interest rates attained an average of 24 percent during 1988.19

High real interest rates impinged negatively on the fiscal deficit as shown in Table 5; issuance of domestic debt continued to be the most important source of financing of the fiscal deficit. As fiscal deficits increase, further issuance of domestic public debt becomes necessary, raising real interest rates even further and depressing economic activity. The slowdown in economic growth would, in turn, increase the attractiveness of the inflationary tax relative to the issuance of government bonds as a source of financing for the fiscal deficit. Indeed, as it was evident from the behavior of the monetary aggregates, the Government at times intervened in the credit market to prevent further rises in interest rates, reinforcing expectations about a probable abandonment of the program.

The Policy Response: Overshooting the Primary Surplus and the Depreciation of the Mexican Peso

As shown in Table 4, the high real interest rates experienced during 1988 implied that the estimated proxy for the inflation tax rate needed to finance the fiscal deficit in the long run would have reached almost 83 percent.20 Although this was below the average inflation rate of that year, it was inconsistent with the objectives of the authorities.

In response, the authorities reinforced their economic program in 1989. The evidence indicates that these policies had the desired effect. As shown in Chart 4, the differential between the spread in the interest rates on CETES and PAGAFES and the preannounced depreciation of the exchange rate declined sharply during 1989–90 and even further during 1991, indicating that the credibility of exchange rate policy improved substantially. Moreover, real interest rates (estimated either on an ex ante or an ex post basis) declined, slowly at first during 1989 and much faster in 1990, especially after the completion of the financing package with commercial banks.21 As a result, the overall public sector deficit declined and new issuance of government bonds as a percentage of GDP declined in 1989 for the first time since 1985, reinforcing the reduction in real interest rates (see Table 5).

An examination of Table 4 suggests that the fiscal adjustment of 1989–90 was somewhat greater than the improvement in the primary surplus needed for price stability in the long run. By 1989, the financing of the fiscal deficit would have been consistent with an estimated proxy for the inflation tax rate of slightly more than 10 percent in the long run, and, by 1990, the maintenance of the observed fiscal stance would have exerted deflationary pressures on the economy. By 1991, the primary surplus is estimated to have declined to 6 percent of GDP. In light of the previous discussion, the decline in the primary surplus appears compatible with a further reduction in the inflation rate.

In the context of the improved credibility of government policies and the associated recovery of the Mexican economy, a question remains: to what extent does the incomes policy associated with the social pact still impose a distortion on relative prices and, therefore, a constraint on growth? Chart 5 shows the ratio of controlled items and noncontrolled items. While the ratio declined sharply during 1988 and part of 1989, it started increasing again by the end of 1989 and, by mid-1990, was close to unity. This pattern indicates that the distortions in relative prices originally created by the pact have been, at least partially, reversed in recent years. Moreover, although real minimum wages have remained well below wages negotiated in the free market, it is important to recall that only about 20 percent of the labor force receive minimum wages. These developments taken together indicate that the pact has incorporated a great deal of flexibility and that, implicitly, the authorities have chosen to abandon it in a gradual form. To a large extent, it appears as if, de facto, the social pact no longer constrains the functioning of efficient resource allocation in the Mexican economy.

Chart 5.
Chart 5.

Ratio of Inflation Rates Between Controlled and Noncontrolled Items

Conclusion

This section has used a simple framework based on the government budget constraint to analyze the consistency of macroeconomic policies undertaken by the Mexican authorities during the period 1978–91.

An important conclusion derived from examining this experience is that the interaction between the actual implementation of economic policies and economic agents’ perceptions about the sustainability of those policies can explain, to a large extent, the behavior of certain key macroeconomic variables during the three subperiods under study. For example, the persistence of large fiscal deficits during 1978–81 created substantial inflationary pressures in the economy, even when a large proportion of those deficits was financed through foreign loans and output was expanding. As concern about the unsustainability of fiscal policy increased, domestic economic agents moved away from domestic money in the expectation that the Government would increasingly need to rely on the inflationary tax as a source of finance and on a devaluation of the Mexican peso. Inflationary expectations were validated in 1982. As capital flight accelerated and new foreign loans to Mexico were severely curtailed, the Government increased its reliance on monetary financing; inflation increased sharply and the economy experienced a balance of payments crisis that ended with a large depreciation of the Mexican peso.

Concern about the sustainability of the fiscal and monetary efforts was also a major factor limiting the success of adjustment programs in the period 1983–87. After a partial reduction of inflation during 1983–84 resulting from a substantial improvement in the fiscal stance, existing rigidities in the fiscal structure and adverse shocks resulted in a reduction of the fiscal primary surplus. As the fiscal stance deteriorated, the Government relied increasingly on the issuance of domestic debt. Fiscal deficits exerted inflationary pressures, even when domestic bond issuance rather than money was mostly used as a financing instrument, as the resulting rise in real interest rates increased the probability that the Government would resort to the inflationary tax and to an acceleration of the rate of depreciation of the peso.

The analysis of the Mexican experience from 1978 to 1987 led to an important lesson: Although tight fiscal and monetary policies were essential tools in achieving a sustainable reduction in inflation in the long run, rigidities in the public and financial sectors, as well as lack of access to foreign credit markets, made economic programs vulnerable and highly sensitive to adverse shocks. Moreover, it was evident that economic agents’ concerns about the maintenance of the announced policies could jeopardize the adjustment efforts by inducing capital flight and balance of payments problems. These considerations were at the core of the design of the comprehensive program launched by the Government in December 1987. Incomes policy was implemented as a complement to tight fiscal and monetary policies to control inflationary expectations.

Appendix I Real Interest Rates in Mexico

Real Interest Rates in Mexico

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Note: CETES = peso-denominated Mexican treasury bill.

Three-month CETES minus the inflation rate observed in the subsequent quarter.

For the period 1978:1–1988:2, data correspond to estimations using an autoregressive process of the following form: Δpt = 0.0238+ 0.8497 Δpt-1 + ut where Δpt is the inflation rate in period t and ut is a white noise disturbance. For the period 1988:3–1991:1, data are taken from Section VIII of this report.

Three-month CETES minus the inflation rate expected to prevail in the subsequent quarter.

Appendix II Derivation of the Steady-State Requirement for Inflationary Finance

From equation (2) in the main text, the derivation of the proxy for the steady-state rate of inflation consistent with the fiscal deficit requires estimating the value of def, m, dd, Δfd and p. The estimation of def has already been discussed and presented in Table 3. While the series for m (the stock of domestic money—defined here as Ml—as a proportion of GDP) and dd (the stock of public sector domestic debt—excluding debt held by the Central Bank—as a proportion of GDP) have been obtained from the Banco de Mexico, it is necessary to introduce some assumptions regarding the steady-state rate of output growth (p) and the sustainability of foreign finance for each subperiod under study.

With respect to the steady-state rate of growth of output, the following considerations were taken into account:

(a) Although actual real GDP grew at an average rate of about 8 percent during the period 1978–81 fueled by a rapid rise in government expenditures, it is widely agreed that such real growth could not be sustainable. Since the addition of foreign resources had little impact on productive capacity, it is assumed here that the sustainable rate of growth during the period 1978–81 did not differ substantially from the average rate of about 4 percent experienced in the previous four-year period—1974-77.

(b) In the context of a sharply reduced access to international capital markets during the period 1982–87, Mexico experienced an average rate of growth of—2 percent. While part of such negative growth was due to exogenous adverse factors, it is assumed here that the debt-overhang problem (i.e., the effects of a large outstanding external debt on domestic private investment) and the associated lack of investors’ confidence in the Mexican economy imposed a zero rate of growth constraint in the economy during that period.

(c) On the basis of the comprehensive adjustment and structural program that has been undertaken by the authorities since 1988 and the significant debt-reduction operations conducted under the Brady plan, a sustainable rate of growth of 1 percent was assumed for 1988 and a rate of 3.5 percent was assumed for the period 1989–90. A higher rate of growth for 1989–90 relative to 1988 reflects the assumption of a positive effect on output growth of the reduction in the stock of debt.

Next, it is necessary to specify assumptions regarding the sustainable flow of public sector external debt. The issue of the sustainability of external debt inflows, as discussed earlier, arose in Mexico during the period 1978–81.22 Two elements were considered here:

(a) Large amounts of capital flight accompanied the increase in external debt during this period. Since, by definition, capital flight constitutes resources that are not used to increase the productive capacity in the economy, it is necessary to subtract capital flight flows from total foreign inflows in order to obtain an approximate magnitude of the funds available to finance the government budget deficit. Therefore, estimates of the stock of capital flight were subtracted from the recorded stock of public sector debt to obtain an estimate of the adjusted stock of foreign debt available for financing the activities of the public sector.

(b) The condition that the government be solvent on a long-run basis in the sense of being able to repay its outstanding debt was assumed here.23 This solvency condition, which requires that the present value of foreign debt be nonnegative, was imposed on the estimated adjusted stock of foreign debt to obtain an estimation of the inflow of foreign debt that could have been repaid without rescheduling operations. The estimations yielded the following approximation for the sustainable inflow of foreign debt as proportion of GDP (Δf):

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As shown above, the actual net inflow of foreign capital during the period 1978–81 was much greater than the net flow of foreign debt that would have been consistent with the solvency condition.

References

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  • Buffie Edward F., Economic Policy and Foreign Debt in Mexico,” in Developing Country Debt and Economic Performance, Vol. 2, ed. by Jeffrey D. Sachs (Chicago: University of Chicago Press, 1990), pp. 393551.

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  • Calvo Guillermo, and Roque FernandezPauta Cambiaria y Deficit Fiscal” in Inflacion y Estabilidad, ed. by Roque Fernandez and Carlos A. Rodrigues (Buenos Aires: Ediciones Maachi, 1982), pp. 17579.

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  • Chicago Mercantile Exchange, International Money Market Yearbook, various issues.

  • El-Erian Mohamed, Mexico’s External Debt and the Return to Voluntary Capital Market Financing,” IMF Working Paper, WP/91/83 (Washington: International Monetary Fund, August 1991).

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  • Gil Diaz Francisco, and Paul Ramos TerceroLessons from Mexico,” in Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. by Michael Bruno and others (Cambridge, Massachusetts: MIT Press, 1988), pp. 36190.

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  • Guidotti Pablo E. and Manmohan S. Kumar Domestic Public Debt of Externally Indebted Countries, IMF Occasional Paper, No. 80 (Washington: International Monetary Fund, 1991).

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  • Khor Hoe E., and Liliana Rojas-SuarezInterest Rates in Mexico: The Role of Exchange Rate Expectations and International Creditworthiness,” Staff Papers, International Monetary Fund (Washington), Vol. 38 (December 1991), pp. 85071.

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  • Rojas-Suarez Liliana, Risk and Capital Flight in Developing Countries” in Determinants and Systemic Consequences of International Capital Flows, IMF Occasional Paper, No. 77 (Washington: International Monetary Fund, 1991), pp. 8392.

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  • Zedillo Ernesto, The Mexican External Debt: The Last Decade,” in Politics and Economics of External Debt Crisis: The Latin American Experience, ed. by Miguel S. Wionczek in collaboration with Luciano Tomassini (Boulder and London: Westview Press, 1985), pp. 294324.

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1

A similar framework is contained in Calvo and Fernandez (1982). A fiscal framework was also utilized by Guidotti and Kumar (1991) in their analysis of domestic public debt of externally indebted developing countries.

2

Thus, -prim represents the primary fiscal deficit.

3

In this simplified characterization of the long run, the rate of growth of both money and domestic bonds is assumed to equal the rate of growth of nominal GDP. That is, the long run is identified with a steady state equilibrium where the level of real variables is kept constant.

4

The time subscript has been deleted since equation (2) represents the fiscal budget constraint in the steady state.

5

Gil Diaz and Tercero (1988) also uses the arithmetic of the budget constraint to answer a related question: What would be the necessary primary balance consistent with price stability in the Mexican economy?

6

The estimated inflation rate derived from equation (2) would equal the “true” long-run rate only in those periods where the observed ratios ddt and mt do not differ significantly from their longrun values. This is, of course, highly unlikely in the high-inflation years of the Mexican economy.

7

In the absence of evidence on the “true” rate of discount used by economic agents to estimate the present value of their assets, the ex post real interest rate, that is, the nominal interest rate minus the observed inflation rate is a concept widely used. However, agents base their decisions on portfolio allocation on the ex ante real interest rate, that is, the nominal interest rate minus the expected inflation rate.

8

A comprehensive analysis of the Mexican economy covering developments since the late 1950s to 1986 is contained in Buffie (1990).

9

Once again, it is important to recall that the usefulness of this exercise lies in evaluating the long-run consistency between fiscal policies and other key macroeconomic variables, but cannot be used to explain the behavior of either inflation or economic activity. Such a task would require the specification of a complete macroeconomic model.

10

Moreover, Appendix II shows that the net flows of foreign debt consistent with satisfying the condition that the government be solvent on a long-run basis (in the sense of being able to repay its outstanding debt) were much lower than the actual flows.

11

The studies by Ramirez-Rojas (1985) and Ortiz (1983) show that the phenomenon of currency substitution—the substitution of foreign money for domestic money by domestic residents—was evident in Mexico during this period. Their empirical analyses show that holdings of domestic real money were inversely related to expectations about the devaluation of the Mexican peso.

12

In addition, deposits in U.S. dollars denominated accounts also increased sharply. Perceptions of a possible devaluation were rein-forced in mid-1981 when developments in the oil market indicated that the planned sales of oil by the Mexican Government could not be made without a reduction in the price of oil. (See Zedillo (1985) for a further discussion of these developments.)

13

The perception of economic agents regarding the probability of a devaluation are examined in Blanco and Garber (1986).

14

See Section II for a description of the fiscal effort during this period.

15

The $3.4 billion of net external financing in 1983 reflects new loans amounting to $5 billion to the public sector in the context of rescheduling operations with commercial banks. Indeed, during the period 1983–90, new credit to the Mexican Government was largely accounted for by official credit and restructural arrangements with external commercial banks.

17

Also, see Ortiz (1991).

18

See Khor and Rojas-Suarez (1991) for a study on interest rate parity in Mexico.

19

International perceptions of Mexico’s creditworthiness also contributed to the persistence of high real domestic interest rates. As shown in Khor and Rojas-Suarez (1991), the evidence suggests that the domestic and external U.S. dollar-denominated debt issued by Mexico are linked on the basis of default risk, that is, there appears to be no perceived differences in the credit standing of domestic and external debt of Mexico, implying that both kinds of debt are subject to the same country risk premium. Since the price in the secondary market for Mexican external debt reflects a risk premium associated with the probability of default, the paper shows that domestic interest rates of Mexican assets denominated in U.S. dollars are closely linked to the behavior of the implicit yield derived from the secondary market for Mexican debt. Perceptions of default risk on total Mexican debt (either domestic or external) would then contribute to the persistence of high real interest rates.

20

To the extent that the persistence of economic policies would have reduced real interest rates even in the absence of further adjustments in the fiscal deficit, the “true” long-run inflation tax rate would have been lower.

21

An examination of the real interest rate on a quarterly basis (presented in Appendix I) indicates that ex ante real interest rates declined sharply during the third and fourth quarter of 1989 following the announcement of an agreement with commercial banks to reduce Mexico’s external debt and debt-service obligations. See also El-Erian (1991).

22

The issue of sustainability of foreign inflows did not arise during the period 1983–89, since external creditors largely ceased to extend loans to Mexican residents during that period. In this section, sustainable private foreign flows were then assumed to equal zero during that period. Since the signature of the agreement on the financing package with commercial banks in early 1990, Mexico has started its return to voluntary capital market financing. It is in this context that, for 1990, actual foreign flows are assumed to be consistent with the long-run solvency requirement of the Mexican Government.

23

The solvency condition implies that the rate of growth of foreign debt to GDP should be lower than the foreign interest rate minus the rate of output growth. See Blanchard (1990) and Horne (1991).

The Strategy to Achieve Sustained Economic Growth
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    Interest Rate Differentials Versus Exchange Rate Depreciation

    (In percent a month)

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    Ratio of Inflation Rates Between Controlled and Noncontrolled Items