This paper focuses on the Mexican economy, its output fluctuations, and analyzes the country's external competitiveness in the context of medium-term external current account sustainability. The study also presents different measures of the fiscal deficit, including the traditional budget balance, and reviews measures on the fiscal stance and fiscal impulse. It examines the evolving relationship between inflation and the exchange rate, using fixed and time-varying coefficient models. The paper describes the methodology, provides the rationale for estimating time-varying parameter models, and presents the estimation results.

Abstract

This paper focuses on the Mexican economy, its output fluctuations, and analyzes the country's external competitiveness in the context of medium-term external current account sustainability. The study also presents different measures of the fiscal deficit, including the traditional budget balance, and reviews measures on the fiscal stance and fiscal impulse. It examines the evolving relationship between inflation and the exchange rate, using fixed and time-varying coefficient models. The paper describes the methodology, provides the rationale for estimating time-varying parameter models, and presents the estimation results.

II. External competitiveness and Current Account Sustainability1

A. Introduction

1. After years of robust growth, the deterioration in the U.S. economic outlook coupled with lower oil prices and the continued appreciation of the real exchange rate have focused attention on Mexico’s external current account deficit and external competitiveness. This chapter analyzes Mexico’s external competitiveness in the context of medium-term external current account sustainability. First, some indicators of external competitiveness are considered. Second, some exercises on current account sustainability are carried out using different methods and an equilibrium exchange rate based on a sustainable current account level is arrived at. Third, a set of indicators that have been found to have predictive power for financial crises are analyzed.

2. Although the real exchange rate has appreciated substantially in recent years and the non-oil current account has deteriorated, other indicators tend to mitigate these concerns. The current account sustainability analysis yields different results depending on the method used. According to the first method (stable external debt-to-GDP ratio), the current account projected over the medium term is sustainable and hence no exchange rate adjustment is required. According to the second method (stable net foreign liabilities-to-GDP ratio), a modest real effective exchange rate adjustment would be needed to reduce the current account deficit to a sustainable level. Finally, a third method (based on current account norms), suggests the need for a more substantial real effective exchange rate adjustment. However, this third criterion may have limited usefulness in estimating the sustainable current account deficit going forward, given that it does not take into account the profound structural changes that the Mexican economy has undergone in recent years.

B. Some Indicators of External Competitiveness

3. The most widely used indicator of external competitiveness is the real effective exchange rate (RER). Mexico’s CPI-based RER has appreciated since 1995 and was 11 percent above its 1994 average as of March 2001. However, this measure does not consider productivity trends. Hence, an alternative measure, based on relative unit labor costs (ULC), is commonly used to complement the CPI-based measure (Figure 1). Although the ULC-based RER has appreciated less than the CPI-based measure, and is still some 7 percent below its 1994 average, it nevertheless displays a very similar trend to that of the CPI-based indicator. This raises some concerns, because the appreciating trend of the RER has been accompanied by a widening of the non-oil current account deficit and may thus suggest that the real appreciation is reducing the competitiveness of Mexico’s traded goods sector (Figure 2). It should be noted that the real appreciation of the peso has partly resulted from an improvement in the terms of trade, in turn because of favorable oil price movements, and hence the overall current account deficit has not deteriorated by the same amount.

Figure 1.
Figure 1.

Mexico: Real Effective Exchange Rate (based on unit labor costs)—Real Effective Exchange Rate (based on consumer prices)—1994 = 100, += appreciation

Citation: IMF Staff Country Reports 2001, 191; 10.5089/9781451825572.002.A002

Figure 2.
Figure 2.

Mexico: External Non-oil Current Account Deficult and Real Effective Exchange Rate

(In percent of GDP and 1994=100)

Citation: IMF Staff Country Reports 2001, 191; 10.5089/9781451825572.002.A002

4. Some private sector analysts justify the strength of the peso in light of favorable developments in fundamentals. However, several analysts caution that the peso appreciation of the last few years may be excessive. Some private sector models that predict crisis probabilities have registered an increase in this probability for Mexico (which, however, remains low) partly because of the real exchange rate appreciation.

5. Nevertheless, there are some elements that ease the above-mentioned concerns. First, non-oil Mexican exports have gained market share in recent years. Figure 3 shows an average yearly increase in market share of 4 percent over the period 1995-2000. Moreover, this is with respect to all of Mexico’s trading partners, and hence does not represent the effect of trade redirection that has taken place since the inception of NAFTA. Second, the seasonally adjusted (SA) non-oil trade deficit has been narrowing in recent months falling to US$2.0 billion in February-April compared with US$2.2 billion in the previous three-month period. The growth of trade (both exports and imports) has dropped markedly, starting from late-2000. The fall in non-oil exports has been more than offset by import weakness—in February-April 2001, non-oil exports fell by 1.7 percent a month (SA basis), compared with a decline of 1.8 percent a month for imports in February-April. Nevertheless, this could reflect the effect of the business cycle, given that, not only has the U.S. economy decelerated markedly, but so too has the Mexican economy, which follows the U.S. cycle very closely.

Figure 3.
Figure 3.

Mexico: Market Share of Non-oil Exports

(Annual percentage change)

Citation: IMF Staff Country Reports 2001, 191; 10.5089/9781451825572.002.A002

6. Finally, another factor that could assuage concerns relating to the RER is the fact that import and export elasticities with respect to the RER are low and are only a fraction of the elasticities with respect to demand. Nevertheless, this can be a double-edged sword, as will become apparent in the next section.

C. Assessing Current Account Sustainability

7. One method often used to assess external competitiveness is to determine a sustainable level of the current account balance and then define the equilibrium RER as that exchange rate index that is consistent with the sustainable current account balance. Hence, the lower the export and import elasticities with respect to the real exchange rate, the larger the exchange rate adjustment required to achieve the sustainable level of the current account balance.

8. There are several ways to define a sustainable current account deficit. The most commonly used is the one that satisfies the criterion that the total-external-debt-to-GDP ratio should not increase.2 The results of this sustainability analysis are reported in Table 1. The latter presents the minimum noninterest current account surplus required to maintain the external-debt-to-GDP ratio constant for different combinations of the real GDP growth rates and real interest rates on foreign debt.

Table 1.

Current Account Sustainability: Constant External Debt to GDP Minimum Noninterest Current Account Balance

(In percent of GDP, unless otherwise indicated)

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Source: Fund staff estimates.

9. However, given that oil exports are an important component of Mexico’s current account receipts—oil exports accounted for 14 percent of total exports in 1995-2000—and oil prices are highly volatile, it would seem more appropriate to define a sustainable non-oil current account balance by subtracting from the values of Table 1, the average level of oil exports calculated over an extended period of time, say five years. This is done in Table 2, using average oil exports during 1995-2000 (2.6 percent of GDP).

Table 2.

Current Account Sustainability: Constant External Debt to GDP Minimum Noninterest Current Account Balance

(In percent of GDP, unless otherwise indicated)

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Source: Fund staff estimates.

10. In order to calculate the current account balance to be compared to the tables above not only is it necessary to consider the noninterest component of the current account balance, but it is also necessary to subtract the part of the current account deficit which can be financed via nondebt creating flows, such as foreign direct investment or equity inflows or a draw down of assets abroad. Hence, the financing mix affects this measure of sustainability.

11. The medium-term projections contained in the accompanying staff report, assume that the average real interest rate on Mexico’s external debt is relatively stable at about 5 percent—the same rate that Mexico paid in 2000—as the decline in Mexico’s spreads is expected to be offset by a rise in international interest rates. Table 3 presents the growth assumptions underlying the medium-term projections as well as the “adjusted” current account balance (both overall and non-oil) over the forecasting horizon. These figures can then be compared either with those of Table 2 or Table 3. The projected current account balances are always higher than what would be indicated by the stable debt-to-GDP ratio criterion. Indeed, our medium-term projections forecast a modest decline in the external debt-to-GDP ratio to 22 percent in 2006 from 26 percent at end-2000 (Figure 4). This is also affected by the projection of FDI flows, expected to continue to be strong and amounting, on average, to some 60 percent of the current account deficit, as the Mexican economy becomes even more integrated with the U.S. economy.3 In other words, given our medium-term macroeconomic forecasts and using the criterion of a stable external-debt-to-GDP ratio, Mexico’s current account deficit is sustainable. More importantly, in our projections Mexico’s current account deficit allows for a reduction in the debt-to-GDP ratio, even when the domestic economy and its main trading partner, the United States, return to their respective potential output growth rates and close the output gap.

Figure 4.
Figure 4.

Mexico: Total External debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 191; 10.5089/9781451825572.002.A002

Table 3.

Medium-Term Projections

(In percent of GDP, unless otherwise indicated)

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Sources: National Institute of Statistics and Geography (INEGI); World Economic Outlook; and Fund staff projections.

12. A second approach used in the literature is one that defines the sustainable current account balance as that balance that maintains the ratio of net foreign liabilities (NFL) to GDP constant. The difference with the previous approach is that the way in which the current account is financed does not matter. This has been argued on the grounds that a country cannot continuously accumulate foreign liabilities, not just foreign debt.4 Further, foreign assets are also taken into account. The first difficulty in these calculations is to determine the initial stock of Mexico’s net foreign liabilities, given that Mexico does not yet produce statistics on the international investment position. The estimates of Lane and Milesi-Ferretti (LM-F 1999) for the end-1997 stock have been utilized and then updated using the cumulative current account deficits in the years 1998-2000. Given that LM-F had two different estimates (one based on cumulative current account balances and one on stocks of foreign assets and foreign liabilities), an average of the two is used.5 Following this procedure, Mexico’s stock of net foreign liabilities at end-2000 is estimated to have been 37.6 percent of GDP.

13. The results of this sustainability exercise are presented in Table 4, which shows the minimum balance on goods, nonfactor services, and transfers required to keep the net-foreign-liability-to-GDP ratio constant for various growth rates and net real rate on foreign liabilities.6 Table 5 presents the same calculations for the non-oil balance.

Table 4.

Current Account Sustainability: Constant Net Foreign Liabilities to GDP Minimum Goods, Nonfactor Services, and Transfers Balance

(In percent of GDP, unless otherwise indicated)

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Source: Fund staff estimates.
Table 5:

Current Account Sustainability: Constant Net foreign Liabilities to GDP Minimum Non-Oil Goods, Nonfactor Service and Transfer Balance

(In percent of GDP, unless otherwise indicated)

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Source: Fund staff estimates.

14. These figures can be compared with the projections for the goods, nonfactor services, and transfer balance reported in Table 3, considering that in the forecasting horizon the net real rate on foreign liabilities is about 3 percent. As can be deduced from this comparison, the projected balance is short of that necessary to maintain a constant NFL-to-GDP ratio. Indeed, Figure 5 shows a modestly rising trajectory for net foreign liabilities over the forecast horizon. Hence, according to this criterion the real exchange rate would appear somewhat overvalued.

Figure 5.
Figure 5.

Mexico: Net Foreign Liabilities

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 191; 10.5089/9781451825572.002.A002

15. A third approach it to calculate current account norms, by estimating the long-run determinants of savings and investment. The Research Department of the Fund has applied this approach to several emerging market countries based on Chinn and Prasad (2000) using cross-section and panel data from 1980 to 1995.7 From the estimations, the current account balance is positively correlated with the government budget balance, the initial level of net foreign assets, and terms of trade volatility,8 while negatively correlated with the degree of openness of the economy. The estimated current account deficit norm for Mexico is 1½ percent of GDP (see Isard, Faruqee, and Prasad, 2000) and hence significantly lower than our medium-term forecasts.9

16. Each of the methods discussed above has some limitations. The first and second criteria can be criticized on the grounds that although they provide conditions for either the debt-to-GDP ratio or the NFL-to-GDP ratio to stabilize, they are silent on the appropriateness of a specific level for these variables. The third criterion can be criticized on the basis that, for an economy that is undertaking important structural changes, the reliance on a long historical period to determine the sustainable current account deficit is affected by factors that are no longer relevant. In the case of Mexico, the numerous financial crises which have occurred in the sample period bias downward the sustainable current account deficit obtained using this method, by not adequately taking into account the improvements in the economy’s fundamentals and financial strength of the past five years and the much greater access to international capital markets.

17. Given the limitations of the methods used to define the sustainable current account balance, the analysis above is complemented by a set of indicators that have been found to have predictive power in identifying unsustainable current account deficits, i.e., current account deficits that lead to financial crises and require abrupt and drastic changes in policies, as suggested by Milesi-Ferretti and Razin (1996).10 A set of indicators of current account sustainability is presented in Table 6, including: the level of savings and investment, the fiscal balance, the openness of the economy, and the composition of external liabilities. The indicators shown in Table 6 paint a generally positive picture. The planned fiscal reform is expected to reduce considerably the fiscal deficit, allow for an increase in investment without putting pressure on the external accounts, and improve competitiveness. As already mentioned above, external debt is projected to decline over the medium term and the debt-service ratios to improve. Moreover, Mexico can finance over 60 percent of its current account deficit with FDI and short-term flows have become a very small part of the capital account since the introduction of the floating exchange rate regime. The proportion of all (including repayments on medium- and long-term debt) short-term debt is less than a third of total external debt and is almost entirely covered by official reserves.

Table 6:

Indicators of Current Account Sustainability

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Sources: Mexican authorities; and Fund staff estimates.

18. Other important qualitative indicators that Milesi-Ferretti and Razin find important are the health of the financial sector and the exchange rate policy. On this front, Mexico scores well as the health of the financial system has dramatically improved in recent years and the exchange rate regime is very close to a clean float. It could be argued that the fact that the exchange rate regime is flexible should affect the interpretation of RER developments, as the actual RER can be considered an equilibrium exchange rate and exchange rate adjustments are not delayed because of the authorities’ defense of an unsustainable exchange rate level. Moreover, even if a substantial RER adjustment were to take place, say 20 percent, this is unlikely to cause a financial crisis, as experienced by Mexico up to 1995, given that the floating exchange rate has discouraged the build-up of significant balance sheet exposures to exchange rate risk. The events of 1998 corroborate this view.

19. Indeed, the type of balance sheet imbalances that typically develop in a fixed exchange rate regime are absent in Mexico at present. Commercial banks have a foreign exchange position, which is typically close to zero. The public sector has been reducing its external-debt-to-GDP ratio very aggressively—the end-2000 level was 15 percent compared to 41 percent at end-1995 and, moreover, the repayment schedule is smooth. The private corporate sector appears to have a short foreign exchange position, but its size, at about US$15 billion for firms quoted on the stock exchange (about 15 percent of their annual foreign sales) appears manageable and concentrated in export firms.12 Nevertheless, a substantial exchange rate adjustment may well have implications for the inflation target and other macroeconomic variables, thus requiring some policy adjustments.

D. Conclusion

20. The analysis conducted above produced mixed results regarding the appropriateness of Mexico’s external competitiveness level. While real exchange rate measures show a substantial appreciation in recent years—with the RER back to the levels reached before 1994—and the non-oil current account balance has been deteriorating, Mexico’s exports are gaining market share. An exercise aimed at calculating a sustainable level for the current account balance using different methods showed that according to one of the sustainability criteria (stable debt-to-GDP ratio), the real exchange rate is not overvalued, while the criterion of a stable net foreign liabilities-to-GDP ratio points to a modest overvaluation. The third criterion examined, based on current account norms, suggests that the extent of overvaluation is more substantial. However, this criterion may be of limited usefulness going forward, as it does not take into account the profound positive changes of the Mexican economy of the last five years. Finally, examining jointly a variety of indicators that have been found to have predictive power in financial crises, a generally positive picture emerges.

1

This chapter was prepared by Laura Papi.

2

The standard formula used is CA*/GDP=(r-g) D/GDP, where the CA* denotes the noninterest current account balance that has to be financed via debt-creating flows, r the average real interest rate paid on external debt, g the real GDP growth rate and D the country’s total external debt.

3

The Citigroup’s US$12.5 billion acquisition of Banamex, expected to be completed in the fourth quarter of 2001, is reflected in an increase in assets in 2001, but in subsequent years, these assets are assumed to be partially drawn down and hence would be a nondebt creating source of current account financing.

4

The concept of foreign liabilities is broader than external debt. For example, it includes also the stock of foreign direct investment.

5

The estimates of Lane and Milesi Ferretti were 40.6 percent of GDP and 43.2 percent of GDP at end-1997.

6

The formula used in these calculations is: CA**/GDP= (r’-g) NFL/GDP, where CA** denotes the balance on goods, nonfactor services and transfers, r’ the average net real rate on foreign liabilities (this would be the foreign interest rate for the part of foreign liabilities accounted for by external debt, and dividend payments on equity investments and such minus the rate earned on foreign assets).

7

Chinn and Prasad (2000), “Medium-term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration,” NBER Working Paper 7581, March 2000 and IMF Working Paper WP/00/46.

8

Terms of trade volatility is expected to increase savings, due to a higher degree of uncertainty.

9

Isard, Faruqee, and Prasad (2000), “Proposed saving-investment norms for nonindustrial countries”, IMF mimeo.

10

Milesi-Ferretti and Razin (1996), “Current Account Sustainability,” Princeton Studies in International Finance, No. 81, October.

12

However, as the private corporate sector has been the main intermediary of capital inflows in recent years, either on its own account or for the financing of PIDIREGAS projects, closer monitoring is warranted. It is possible that the sample used to gather information about the foreign exchange (FX) position of the corporate sector is not representative of the whole economy or that on-lending practices to smaller enterprises, which do not have access to international capital markets, are transferring the FX risk to firms that are less well equipped to bear it.

Mexico: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Mexico: Real Effective Exchange Rate (based on unit labor costs)—Real Effective Exchange Rate (based on consumer prices)—1994 = 100, += appreciation

  • View in gallery

    Mexico: External Non-oil Current Account Deficult and Real Effective Exchange Rate

    (In percent of GDP and 1994=100)

  • View in gallery

    Mexico: Market Share of Non-oil Exports

    (Annual percentage change)

  • View in gallery

    Mexico: Total External debt

    (In percent of GDP)

  • View in gallery

    Mexico: Net Foreign Liabilities

    (In percent of GDP)