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.
1. The following information, which does not change the thrust of the staff appraisal, has become available since the staff report (SM/02/260) was issued to Executive Directors.
Recent economic developments
2. Recent data confirm that economic activity rebounded strongly in the second quarter of 2002, following 6 quarters of contraction or stagnation. Real GDP grew by 1.2 percent on a seasonally adjusted basis, as exports were supported by stronger demand from the United States, and final domestic demand grew sharply (by 2.8 percent) following several quarters of weakness. Indicators for the third quarter are mixed. Both industrial production and non-oil exports were about unchanged in July (compared with the second quarter); however, employment in the formal sector grew by 1½ percent during this period.
3. The 12-month inflation rate rose further to 5.3 percent in August 2002 (compared with the end-year target of 4.5 percent), owing to increases in administered prices. As a result, inflation expectations have risen to close to 5 percent for 2002, notwithstanding the further decline in core inflation to under 4 percent from over 5 percent in December 2001.
4. In the first half of 2002, the overall external current account deficit is estimated to have reached 2.1 percent of GDP, slightly smaller than reported in the staff report. About 90 percent of the deficit during this period was financed by net inflows of foreign direct investment.
Recent financial market developments
5. Market sentiment towards Mexico continues to be positive. Sovereign bond spreads have narrowed from 418 basis points in mid-August to around 400 basis points (as of September 17). Mexican issuers have maintained access to international capital markets and the local corporate bond market has also remained active. Last week, the federal government issued US$1.75 billion in 20-year global bonds at a spread of 353 basis points. Most of the proceeds from the bond sale (US$1.3 billion) will be used to retire Brady bonds, while the remainder will be used to cover bond redemptions in 2003. On August 21, HSBC Holdings announced that it would acquire Bital (Mexico’s fourth-largest bank) for US$1.1 billion.
6. The peso has depreciated to close to Mex$10 per U.S. dollar from Mex$9.8 per U.S. dollar at end-July, while domestic interest rates have declined slightly to below 7 percent. Gross international reserves have been stable (at approximately US$47 billion).
7. In mid-August, the government sent to congress its proposal for electricity reform, which aims at modernizing the sector and increasing capacity. It involves allowing the full participation of the private sector in electricity generation, and enabling private generators to sell electricity to large (normally corporate) consumers. These changes would entail amending two constitutional articles, which reserve for the public sector the right to sell and generate electricity.
8. As of September 26, banks will be required to establish at the Bank of Mexico (BOM) a compulsory deposit for an indefinite period of Mex$150 billion for the system. The distribution of compulsory deposits among individual banks will be determined on the basis of peso-denominated liabilities. Most of this amount (Mex$95 billion) will replace already existing deposits at the BOM, not all of which are compulsory. The new deposits will carry a lower interest rate than the ones being replaced. The authorities have indicated that this action does not change their monetary policy stance, as any net reduction in liquidity will be channeled back in full to the money market on a daily basis through the BOM’s open market operations. Rather, it is intended to reduce the BOM’s interest costs (strengthening its net income position while lowering that of the commercial banks) and to improve its capacity to conduct monetary policy (as the higher level of compulsory deposits will enable the BOM to maintain a daily net creditor position with the money market with less reliance on open market operations).
9. As noted in the staff report, the sustainability analysis presented in Appendix Box 6 was based on the preliminary methodology proposed in “Assessing Sustainability” (SM/02/166) presented to the Executive Board on June 14, 2002. However, simulating shocks to domestic nominal interest rates for countries such as Mexico, that have experienced significant disinflation in recent years overstates interest rate movements associated with a two-standard deviation increase compared with a comparable shock to domestic real interest rates. Accordingly, the analysis was modified to examine the implications of a two-standard deviation shock to domestic real interest rates (Supplement 1 of the Selected Issues Paper, SM/02/289).
10. The results show a much smaller increase in the public sector debt-to-GDP ratio than the one presented in Appendix Box 6; the profile of the external debt-to-GDP ratio is unchanged. In the revised simulations (see Supplement 1), the public sector debt peaks at less than 53 percent of GDP in 2003 (following a two-standard deviation increase in domestic real interest rates and a decline in real GDP growth). This compares with a peak of close to 70 percent in the simulations presented in the staff report, which were based on a two-standard deviation increase in nominal interest rates.