Mexico: Staff Report for the 2002 Article IV Consultation

This 2002 Article IV Consultation highlights that the economic slowdown in the United States triggered a sharp weakening in Mexican economic activity in 2001 from the rapid pace in the preceding year. There was also a marked deceleration in domestic demand growth, as disposable income was adversely affected by a contraction in employment and confidence sagged. Economic activity rebounded strongly in the second quarter of 2002, as exports were supported by stronger demand from the United States and final domestic demand grew sharply.

Abstract

This 2002 Article IV Consultation highlights that the economic slowdown in the United States triggered a sharp weakening in Mexican economic activity in 2001 from the rapid pace in the preceding year. There was also a marked deceleration in domestic demand growth, as disposable income was adversely affected by a contraction in employment and confidence sagged. Economic activity rebounded strongly in the second quarter of 2002, as exports were supported by stronger demand from the United States and final domestic demand grew sharply.

I. Economic Background

1. Economic activity weakened in 2001 from the rapid pace in the preceding year (Figure 1 and Table 1). Last year’s recession, which was characterized by a 0.3 percent decline in real GDP, was the first in Mexico’s recent history not associated with a domestic economic crisis. The slowdown in the U.S. economy triggered the recession and was reflected in a significant weakening in exports and employment.1 In addition, there was a marked deceleration in domestic demand growth (7½ percentage points). Higher unit labor costs as well as a worsening in business confidence associated with the deterioration in global economic prospects, resulted in a contraction in private investment (following five consecutive years of rapid growth) and a decline of inventories. Notwithstanding continued real wage growth and incentives offered by retailers, private consumption growth fell sharply from the unsustainably rapid pace seen in 2000, as employment cutbacks adversely affected disposable income growth and consumer confidence. The 12-month inflation rate slowed to 4.4 percent at end-2001, well under the target of 6.5 percent; core inflation declined from 7.5 percent in 2000 to 5.1 percent in 2001 (Figure 2).

Figure 1.
Figure 1.

Mexico and the United States Economic Activity

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

Figure 2
Figure 2

Mexico: Inflation

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

Table 1.

Mexico: Selected Economic and Financial Indicators

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Sources: National Institute of Statistics and Geography; Bank of Mexico; Secretariat of Finance and Public Credit; and Fund staff estimates and projections.

A measure of formal sector employment.

Includes extrabudgetary balance.

Treats bank restructuring transfers as interest expenditure.

Includes privatization proceeds.

Includes the IMF and public development banks and trust funds net of the collateral of Brady bonds.

Includes the federal government and public enterprises. Net of federal government liquid assets. Includes PIDIREGAS liabilities.

Includes bank restructuring, debtor-support liabilities, and the debt of public development banks and trust funds. Net of liquid assets of the federal government and IPAB. Also, net of IPAB assets from debt-support operations, in-kind loan collections, and loss-sharing agreements.

Includes the IMF and public development banks and trust funds.

In percent of short-term debt by residual maturity. Historical data include all prepayments.

Mexico: Contribution to Real GDP Growth

(In percent)

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Sources: National Institute of Statistics and Geography; and Fund staff estimates.

2. Signs of a rebound in economic activity emerged in the second quarter of 2002 (Table 2). The global index of economic activity (a proxy for monthly GDP) grew at an average pace of 0.8 percent in April-May (seasonally adjusted; monthly rate), led by higher non-oil exports, investment, and private consumption; employment rose by 1½ percent in the first half of 2002 (seasonally adjusted; annual rate), more than reversing the decline in the second half of 2001. Retail sales registered brisk gains, buoyed by higher employment and a continued recovery in bank credit to the consumer sector. The 12-month inflation rate rose to 4.9 percent in June 2002, owing largely to increased transport and electricity tariffs, and a weather-related hike in food prices; the core inflation rate continued to decline to 4.0 percent. The weakness in domestic demand last year contributed to a narrowing of the external current account deficit to 2.8 percent of GDP from 3.1 percent of GDP in 2000, as both lower oil- and non-oil exports were more than offset by a sharp contraction in intermediate and capital goods imports (Table 3). The external deficit continued to moderate in the first half of 2002 to an estimated 2.5 percent of GDP, with some acceleration in non-oil export growth.

Table 2.

Mexico: Key Economic Indicators

(Annual percent change, unless otherwise indicated) 1/

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Sources: National Institute of Statistics and Geography; and Fund staff calculations.

For seasonally adjusted series, percent changes are from preceding period.

Mexican Social Security Institute. A measure of formal sector employment.

Table 3.

Mexico: Summary Balance of Payments

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Sources; Bank of Mexico; Secretariat of Finance and Public Credit; and Fund staff projections.

Includes net proceeds from in-bond industries.

Includes pre-payment of external debt.

In 2001, FDI includes the US$12.5billion Citibank acquisition of Banamex. This is reflected in an equal increase in private sector assets in the same year, followed by partial drawdown in the following years.

Includes financing of PIDIREGAS up to 2001 (in line with the authorities presentation). For 2002 financing of PIDIREGAS is considered as a public sector financing item.

Defined here as the sum of the current account deficit, debt amortization (including pre-payments, short-term debt and IMF repurchases), and gross reserves accumulation.

Excludes balances under bilateral payments accounts.

From 1999, short-term debt excludes pre-payments of public sector debt.

The gross external financing requirement includes the current account deficit and short-term debt by residual maturity, excluding pre-payments of public sector debt starting from 1999.

Includes the IMF and public development banks and trust funds. Includes debt associated with PIDIREGAS.

3. The external current account deficit in 2001 was more than financed by foreign direct investment (FDI), reflecting the US$12.5 billion purchase of Banamex by Citibank (more than half of this inflow was offset on a net basis by an associated increase of assets abroad) (Figure 3). Other capital inflows were also strong, helped by investors’ perception of Mexico as a “safe haven” among emerging markets. In the first half of 2002, FDI is estimated to have moderated to more normal levels,2 while portfolio capital inflows were markedly lower (compared with the same period in 2001). Reduced public sector inflows were due to smaller external borrowing, a fall in foreign investors’ holdings of local government bonds, and the significant release of Brady collateral that took place in 2001. At the same time, corporate sector borrowing abroad fell, as firms switched from external to domestic borrowing due to the opportunity to issue with favorable terms in the local corporate bond market and the unsettled conditions in international capital markets.

Figure 3.
Figure 3.

Mexico: Capital Flows

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

4. Net international reserves increased by US$0.8 billion during the first half of 2002, following a gain of over US$9 billion in 2001.3 Gross international reserves amounted to more than US$45½ billion at the end of June 2002, equivalent to 125 percent of short-term debt by residual maturity and 82 percent of annual gross external financing requirements (Table 4).

Table 4.

Mexico: Indicators of External Vulnerability

(12-month percentage change, unless otherwise indicated)

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Sources: Bank of Mexico; National Banking and Securities Commission; National Institute of Statistics and Geography; Infosel; Reuters; Secretariat of Finance and Public Credit; and Fund staff estimates.

From January 1997 onwards, monetary aggregates are based on resident financial institutions only. M2a equals currency in circulation, checking accounts, tune deposits, securities issued by the public sector, securities issued by the private sector, and saving accounts outside SIEFORES.

Includes non-performing loans.

Includes assets sold to FOBAPROA/IPAB.

From January 1997 stricter accounting rules were introduced through December 1999 includes Banamex, Bital, Banorte, BBV, Citibank, Contra, Inveriat, Santander, and Serlin. From January 1999 includes Banamex, BBVA/Bancomer, Bital, Banorte, Santander, and Serf in.

Increase = appreciation.

In U.S. dollar terms net of maquila.

Includes development banks. Excludes PIDIREGAS which at end-2001 were equivalent to S18 billion (2.9 percent of GDP).

The short-term debt by residual maturity includes pre-payment or debt.

5. The authorities made progress in rebalancing the policy mix in 2001 as fiscal policy was tightened on a cyclically adjusted basis (Table 5 and 6)4 In the face of lower-than-budgeted revenues, the authorities implemented expenditure cuts and improved the enforcement of existing tax regulations to broadly achieve their targeted 2001 fiscal deficit of 0.7 percent of GDP. Using a comprehensive definition of the fiscal balance—net public sector borrowing requirement (PSBR)—the 2001 deficit was about unchanged at 3.8 percent of GDP.

Table 5.

Mexico: Financial Operations of the Public Sector

(In percent of GDP, unless otherwise indicated)

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

Oil revenue includes extraction rights, PEMEX net revenue, PEMEX excess return levy, and IEPS on gasoline.

Excludes nonrecurrent revenue. The authorities also publish the net public sector borrowing requirement including nonrecurrent revenue.

Includes PIDIREGAS financing.

Treats bank restructuring transfers and debtor-support as interest expenditure.

PSBR less oil revenue plus PEMEX operating expenditure.

Includes the external debt of the federal government, public entities, and external debt of development banks.

Table 6.

Mexico: Cyclically Adjusted Public Sector Balances

(In percent of GDP)

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

Estimated as the PSBR plus the additional tax revenue if GDP was at potential (with unitary elasticity). The cyclically adjusted deficit deficit will be lower (higher) than the actual deficit if the economy operates below (above) potential.

Revenue is adjusted to exclude oil export revenue and non-recurrent income. Expenditures exclude the nonrecurrent costs of bank restructuring and debtor-support programs, financial requirements of development banks, and PEMEX operational expenditures.

6. As inflationary pressures declined, the Bank of Mexico (BOM) eased its monetary stance during 2001, which reinforced a sharp decline in short-term domestic interest rates (to 6¼ percent in December 2001 from over 17 percent a year earlier) (Table 7).5 A tightening of monetary policy in February 2002 was reversed in April as the BOM concerns that inflation might rise in response to an unanticipated increase in transportation and electricity tariffs diminished. Interest rates continued to fall through end-April 2002 (to a real rate in ex ante terms of under 1 percent), but that fall subsequently has been reversed (Figure 4).

Figure 4
Figure 4

Mexico: Interest Rates

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

Table 7.

Mexico: Summary Operations of the Financial System

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Sources: Bank of Mexico; National Banking and Securities Commission; and Fund staff estimates.

Difference with annual projections as annual projections are based on fixed nominal exchange rates.

From January 1997 onwards, monetary aggregates are based on resident financial institutions only including deposits of the public sector. There is a break in the series in 2000 due to a reclassification of interbank repo operations.

Currency in circulation, checking accounts, and debits card accounts.

Mia plus time deposits, securities issued by the public sector, securities issued by the private sector, and saving accounts outside SIEFORES.

M2a plus deposits held by non-residents.

M3a plus deposits held in non-resident affiliates and branches of Mexican banks.

Including assets sold to FOBAPROA and assets converted in UDI.

Through December 1998: Banamcx, Banorte, BBV, Bancomer, Bital, Citibank, Confia, Inverlat, Santander, Mexicano. From January 1999: Banamex, Banorte, BBV-Bancomer, Bital, Santander Mexicano, Serfin.

Excluding interest income from AB/FOB APROA notes and before loan-loss provisions.

Interest expenditure plus administrative costs to loan portfolio (excluding assets sold to FOBAPROA).

From January 1997 stricter accounting rules were introduced.

7. Market sentiment toward Mexico remains favorable supported by upgrades of foreign-currency denominated bonds to investment-grade status by both Standard and Poor’s and Fitch IBCA in early 2002.6 This upgrade has contributed to a widening of the investor base, which has helped to mitigate the contagion effects from turmoil in emerging markets (Box 1). Nevertheless, Mexican financial markets have weakened since early-April 2002, reflecting developments in Brazil and the deterioration in U.S. equity markets. International bond spreads (as represented by the EMB1+ for Mexico) increased to around 380 basis points at end-July (from a low of 230 basis points in mid-March), with some indications of an increased correlation of spreads with those of Brazil and the overall EMBI+ index.

Mexico’s Sovereign Bonds and Integration with U. S. Fixed Income Markets

The upgrades to investment grade since 2000 by the major credit rating agencies have led to the inclusion of Mexico in the key U.S. fixed income benchmark (the Lehman Aggregate) and to a broadening of the investor base to include U.S.-based investment grade only (high grade) institutional investors.

Following the broadening of the investor base for Mexico’s external debt after the upgrade by Moody’s in March 2000, the correlation of Mexican sovereign spreads with that of other emerging markets (as represented by the overall EMBI+ index) fell considerably, especially during the period of emerging market turmoil during January through October 2001 (see upper chart). By contrast, the correlation of Mexican spreads with similarly-rated U.S. corporate bonds (as represented by the Merrill Lynch U.S. BBB index) rose. Moreover, Mexico decoupled much earlier from the adverse developments in Argentina (August 2000) than the rest of the major emerging market sovereigns. Since November 2001, however, the correlation between Mexican sovereign spreads and the EMBI+ has increased, as Mexican spreads moved together with the entire emerging markets asset class, whose prices first climbed (in the case of Mexico also helped by S&P’s upgrade in February 2002) and then entered a period of weakness and high volatility (in addition, Mexico’s weight in the EMBI+ increased substantially at end-2001). Further, the correlation with U.S. corporate bonds started declining, as U.S. markets started weakening before Mexican sovereign debt. Nevertheless, Mexico has recently shown incipient renewed signs of decoupling from markets, as well as from the jitters in U.S. corporate, equity, and foreign exchange markets.

uA01fig01

Mexico: Spread Pair-wise Correlations 1/

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

uA01fig02

Mexico: Relative Value

(in bps)

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

In the wake of the upgrades by the credit rating agencies in early 2002, Mexico’s spreads reached a historical low of 233 basis points and for a brief period the differential with the Merrill Lynch U.S. BBB- index disappeared (see lower chart). However, in recent weeks, as both the emerging markets sell off, especially in the rest of Latin America, and renewed weakness of U.S. markets negatively affected Mexico, Mexico’s spreads have risen above U.S. corporates’, even though the differential remains small by historical standards.

8. After trading in a narrow range, the peso depreciated from end-March 2002,7 the depreciation was partly influenced by some market participant’s perception that the (above noted) relaxation of monetary policy was an expression of the BOM’s concern about the sizeable real appreciation of the peso in recent years (Figure 5); it also reflected the weakness of the U.S. dollar against major currencies8 and the general turbulence in emerging markets (Figure 6). The depreciation together with a recent moderation in unit labor costs have contributed to some gain in competitiveness.9 In any case, the peso still has appreciated significantly in real effective terms in recent years both in relation to relative consumer prices and (by less) in relation to unit labor costs.10

Figure 5.
Figure 5.

Mexico: Competitiveness and Wage Indicators

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

Sources: Bank of Mexico; IMF; and INEGI.
Figure 6.
Figure 6.

Mexico: Exchange Rate

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

9. The government has made substantial progress in improving public sector debt management, resulting in a lower cost of funding, longer maturities and reduced external vulnerability. Public sector external debt declined from 42 percent of GDP in 1995 to 16 percent of GDP in 2001 and the sovereign has repurchased or swapped 80 percent of its outstanding stock of Brady bonds through liability management operations (Appendix Box 1). The authorities also have made considerable progress in the development of a domestic debt market and have shifted increasingly toward issuing fixed-rate instruments with longer maturities, enabling an important increase in the average maturity and duration of its domestic debt.11 The stock of domestic government debt in the hands of non-residents also declined dramatically during this period, falling to less than US$2 billion from over US$30 billion in 1995.12 Nonetheless, exposure to short-term and floating interest rates (over 80 percent of domestic debt) and the large gross public sector borrowing requirement (12 percent of GDP) still constitute significant vulnerabilities for the public sector (Figure 7).

Figure 7.
Figure 7.

Mexico: Public Sector Domestic Debt, 2001

Citation: IMF Staff Country Reports 2002, 237; 10.5089/9781451825589.002.A001

II. Policy Discussions

10. The authorities announced their medium-term economic program for 2002-06 (“PRONAFIDE”), while the mission was conducting the Article IV consultation. This program, which establishes the government’s strategy to increase potential output within a stable economic environment, includes two distinct growth scenarios that are differentiated by the degree of the achievement of the structural reforms envisaged in the National Development Plan (NDP). The authorities stressed their determination to carry out successfully the envisaged structural reform program to its fullest. The administration is facing difficulties in gaining approval of its legislative agenda in congress, which is dominated by opposition parties, and politicians already are focusing on the July 2003 congressional and gubernatorial elections.

11. Central to the effort in both of the authorities’ growth scenarios would be further fiscal consolidation, with a reduction in the PSBR to around 1¾ percent of GDP by 2006 (from almost 4 percent in 2002) (Table 8). Critically, with no adjustment budgeted for 2002, a substantial part of the deficit reduction over the period would take place in 2003. It is expected that this planned front-loaded fiscal consolidation would enhance the program’s credibility and affect favorably the public sector debt dynamics, helping to contain the growth of aggregate demand and ease pressure on real interest rates.

Table 8.

Mexico: Medium-Term Financial Operations of the Public Sector

(In percent of GDP)

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

Treats transfers to IPAB as interest payments.

Oil revenue includes extraction rights, Pemex net revenue, excess return levy and IEPS on gasoline.