A. Introduction

1. Many studies suggest that institutional factors play a major role in explaining comparative growth performance across countries and in attaining economic stability.² Against that background, this chapter examines the extent to which Mexico’s fiscal, monetary, and financial institutions provide a basis for the maintenance of economic and financial stability, enabling needed actions in the face of external shocks. The main conclusions are:

• Despite some weaknesses, budget institutions and practices have provided a solid framework in recent years for the execution of fiscal policy, enabling an effective response to external shocks.

• Subnational government finances are not a source of major vulnerability in Mexico. The resource transfers from the federal to the subnational governments are rules–based and would allow for adjustment sharing under a stress scenario.

• Mexico’s independent central bank has gained considerable credibility in recent years in the conduct of monetary policy.

• The Mexican financial system has improved its resilience to shocks in recent years and important progress has been made in the implementation of international standards and codes. As a result, the banking sector is not likely to pose systemic problems.

B. Budgetary Institutions

2. The federal budget consists of two separate legal parts, a federal income law and an expenditure decree. These are prepared by the Ministry of Finance and Public Credit (SHCP) and submitted together to congress for discussion and approval.³ The federal income law is discussed and approved first by both houses of congress (chamber of deputies and senate). Subsequently, the expenditure decree is discussed and approved exclusively by the lower house (chamber of deputies). The federal budget covers the central public administration, the judiciary, congress, the autonomous federal bodies and the parastatal sector under direct budgetary control, which includes social security and some major public enterprises such as PEMEX and the Federal Electricity Commission.

3. Under the prevailing interpretation of the constitution, the congress has ample faculties to amend the budget, including the reallocation of expenditure and changes to the expenditure ceilings and the deficit. While the constitution provides for executive veto, which congress can only override with a qualified majority of ⅔ of the votes, there is controversy concerning the extent to which veto power is applicable to the expenditure decree. In practice, the government has not vetoed congressional amendments to the draft budget (precedents date back to the 1920s). Nonetheless, the deviation between the expenditure decree proposed by the government and the one approved by congress has been small (less than 2 percent), despite some increase in recent years (Table 1).

Table 1.

Mexico: Budget Implementation in Mexico

Source: Secretariat of Finance and Public Credit (SHCP).

Table 1.

Mexico: Budget Implementation in Mexico

	Budgetary Expenditure			Overall Budget Deficit Target
	(in Mex$ million)			(in Mex$ million)		(in percent of GDP)
	Budget	Authorized	Executed	Original	Final	Original	Final
	Proposal	by Congress		(1)	(2)	(3)	(4)
1995	343,271	342,821	425,927	-24	-201	-0.00	-0.01
1996	540,970	540,970	528,533	480	283	0.02	0.01
1997	710,791	710,791	747,298	15,890	-23,011	-0.51	-0.72
1998	856,868	851,387	823,503	-47,348	-47,919	-1.25	-1.25
1999	1,023,438	1,012,767	1,013,905	-58,302	-51,988	-1.25	-1.13
2000	1,169,443	1,176,938	1,247,567	-52,502	-60,597	-1.00	-1.12
2001	1,321,202	1,343,467	1,308,601	-39,935	-42,050	-0.65	-0.73

Source: Secretariat of Finance and Public Credit (SHCP).

View Table

Table 1.

Mexico: Budget Implementation in Mexico

	Budgetary Expenditure			Overall Budget Deficit Target
	(in Mex$ million)			(in Mex$ million)		(in percent of GDP)
	Budget	Authorized	Executed	Original	Final	Original	Final
	Proposal	by Congress		(1)	(2)	(3)	(4)
1995	343,271	342,821	425,927	-24	-201	-0.00	-0.01
1996	540,970	540,970	528,533	480	283	0.02	0.01
1997	710,791	710,791	747,298	15,890	-23,011	-0.51	-0.72
1998	856,868	851,387	823,503	-47,348	-47,919	-1.25	-1.25
1999	1,023,438	1,012,767	1,013,905	-58,302	-51,988	-1.25	-1.13
2000	1,169,443	1,176,938	1,247,567	-52,502	-60,597	-1.00	-1.12
2001	1,321,202	1,343,467	1,308,601	-39,935	-42,050	-0.65	-0.73

Source: Secretariat of Finance and Public Credit (SHCP).

4. While legally possible, supplementary budgets have not been a practice in Mexico. According to the constitution, spending cannot occur in the absence of approval by congress in the expenditure decree or in a separate law during the fiscal year. By law, the SHCP has strong control over the formulation and execution of the budget in dictating the norms and global expenditure limits for the process of budget preparation, establishing general guidelines and mandatory calendars for the actual budget execution and authorizing the re–allocation of expenditure within the budget. Non–interest expenditure can only increase above the approved budgetary appropriations to the extent that excess revenue is being collected.

5. Mexico has a well–articulated system of budgetary audit and control. In addition to the SHCP, the Secretariat of the Comptroller (SECODAM) acts as internal auditor of the public entities included in the budget. All parastatal entities have their financial statements audited by external audit firms as well as by SECODAM. The execution of the federal budget is audited by a recently created audit office (Auditoría Superior de la Federación), which formally belongs to congress but operates independently. The new audit office, which has greater powers than the previously existing Contaduría Mayor de Hacienda, reviews the final annual budget accounts (Cuenta Público) that are sanctioned by congress, performs audits during the fiscal year, and can determine liabilities and penalties for public servants involved in irregularities. It is expected that the audit office’s activity will contribute to improve accountability of government programs and public servants, but its impact will need to be assessed after the new arrangements have been in place for some time.

6. Mexico has established a tradition of including fiscal responsibility principles in its budget to help ensure that the approved expenditure ceilings and deficit targets are met. For example, the expenditure decree for 2002 establishes ceilings on global expenditure and net public indebtedness, as well as a primary surplus target for PEMEX. It includes automatic adjustors, which provide for saving of the bulk of excess revenue and which require offsetting expenditure cuts in the case of revenue shortfalls. Although the government retains discretion in applying these adjustors, the authorities have a track record of abiding by the adjustors to ensure compliance with the fiscal targets. Nonetheless, even if the government opted to ignore the adjustors, the debt ceiling included in the annual income law would provide a legal limit to the overall nominal deficit and, thus, an indirect obligation to adjust expenditure.

7. Overall, the budget institutions and practices have provided a stable framework in recent years for the execution of fiscal policies that are consistent with macroeconomic stability, including dealing with adverse economic circumstances. Notwithstanding the increasing role played by congress in budget discussions in recent years, it has largely respected the deficit ceilings proposed by the government.⁴ Also, as can be seen from the table below, actual budget execution has been very close to the approved deficit limits.

8. The budgetary framework has also demonstrated its resilience in the face of external shocks and during economic downturns. In 1998, the authorities effected expenditure cuts amounting to 0.7 percent of GDP as mandated for by the automatic adjustors in the face of a steep fall in oil revenue. In 2001, budgeted expenditure was again reduced, albeit by a smaller amount, as revenue fell short of the budgeted amount due to a sharp decline in oil revenue and the weakening in economic activity. In early 2002, the authorities cut expenditure preemptively by 0.2 percent of GDP in reaction to poor revenue performance during the first quarter. A portion of this expenditure cut was later reversed in light of higher than budgeted oil revenue in the second quarter.

9. The Fund’s recent fiscal transparency module of the Report on Observance of Standards and Codes (ROSC) indicated that Mexico has made considerable progress in improving transparency in public finances toward compliance with good practices. The assessment included a series of recommendations for further strengthening transparency of budgetary institutions, including a redefinition of the budget’s institutional coverage of government, the presentation of the budget proposal in the context of a quantified medium–term rolling macro–fiscal framework, a more systematic publication of estimates of the effects of new measures, fiscal risks, quasi–fiscal operations, contingent liabilities, and tax expenditures, and stepped–up performance audits and publication of the findings and recommendations of external audits.

10. Fiscal transparency would be further enhanced if the draft constitutional reform, that the government submitted to congress in April 2001, is approved. The proposed reform aims at strengthening the budgetary process and clarifying a series of ambiguities that are present in the current legal framework. It would clarify rules regarding the presidential veto to congressional modifications to the government’s budget proposal; provide more time for discussion of the budget in congress; set clear rules for the conduct of public finances in case the approval of the budget is delayed; allow for the authorization of multi–annual investment projects in the budget; and require that any modification to the draft budget be accompanied with a non–debt creating financing source. In addition, the constitution would include strong fiscal responsibility principles such as a balanced budget rule (over a four–year period), the requirement for the government to present the budget within a medium–term macroeconomic framework and a provision that revenue shortfalls be fully compensated through proportional expenditure cuts.

C. Subnational Governments

11. Subnational governments in Mexico play a limited–but increasing–role in fiscal management Fiscal performance is dominated by the federal government given the specific arrangements among the different levels of government established in the constitution and in the Ley de Coordinatión Fiscal (LCF) approved in 1978. Under these arrangements, all major taxes (income tax, VAT, import tariffs, and excises) are collected by the federal government, while subnational governments levy taxes mostly on real estate and the payroll and derive other income from user fees. More recently, subnational governments have been gradually given increasing expenditure responsibilities and currently account for about ⅓ of total public sector spending. These expenditures are mainly financed with transfers from the federal government, which comprise more than 80 percent of subnational government income. Because of these arrangements, and due to their limited capacity to issue debt thus far, subnational governments have run small surpluses in recent years (Table 2).

Table 2.

Mexico: Subnational Government Public Finances, 1996–2000

(In percent of GDP)

Source: Secretariat of Finance and Public Credit (SHCP).

Table 2.

Mexico: Subnational Government Public Finances, 1996–2000

(In percent of GDP)

		1996	1997	1998	1999	2000
States
	Revenue	5.0	5.8	6.4	6.8	n.a
	Expenditure	4.9	5.7	6.4	6.6	n.a
	Overall balance	0.1	0.1	0.1	0.2	n.a
Municipalities
	Revenue	1.0	1.0	1.2	1.4	n.a
	Expenditure	0.9	0.9	1.1	1.4	n.a
	Overall balance	0.0	0.0	0.1	0.0	n.a
Subnational government debt		1.8	1.5	1.4	1.2	1.1

Source: Secretariat of Finance and Public Credit (SHCP).

View Table

Table 2.

Mexico: Subnational Government Public Finances, 1996–2000

(In percent of GDP)

		1996	1997	1998	1999	2000
States
	Revenue	5.0	5.8	6.4	6.8	n.a
	Expenditure	4.9	5.7	6.4	6.6	n.a
	Overall balance	0.1	0.1	0.1	0.2	n.a
Municipalities
	Revenue	1.0	1.0	1.2	1.4	n.a
	Expenditure	0.9	0.9	1.1	1.4	n.a
	Overall balance	0.0	0.0	0.1	0.0	n.a
Subnational government debt		1.8	1.5	1.4	1.2	1.1

Source: Secretariat of Finance and Public Credit (SHCP).

12. Transfers to the states are made via transparent, nondiscretionary and publicly-known formulas. There are two forms of transfers: The participaciones (which where established under the LCF to compensate states for the revenue foregone to the federal government) are set at 20 percent of tax revenue and oil royalties of the federal government and may be used freely by the states, after transferring a portion (at least 20 percent) to their municipalities. The aportaciones are rules–based transfers earmarked for expenditures in health, education, and social infrastructure, and for institutional strengthening. These have served to formalize previously–existing bilateral agreements between the federal government and the states by which the latter assumed the responsibilities of specific expenditure functions. Total transfers to the states were estimated at 8 percent of GDP in 2001, of which the participaciones represented 40 percent.

13. Subnational government indebtedness is low and has been decreasing in recent years as a percentage of GDP. The total debt of Mexico’s states and municipalities was less than 2 percent of GDP in 2001. Since the debt crisis of 1982, subnational debt has not been a significant problem, although on a number of occasions the federal government has intervened in support of debt–restructuring programs for states and municipalities. The constitution prohibits states and municipalities to issue external debt and limits their domestic indebtedness for investment financing only, within the limits established by their legislatures in their annual budgets.

14. In response to growing demands for increased subnational autonomy and to reduce the likelihood of future bailouts, Mexico adopted a market–based approach to controlling subnational debt in 2000. The federal government’s role as fiduciary agent in subnational government debt contracts (which was perceived by some as an implicit debt guarantee) was abolished and banking regulations were strengthened to increase credit controls. Bank loans to subnational governments now require the rating of two independent credit–rating agencies and have to meet the same credit limits as those of other bank customers. The requirement that all debt contracts be registered with the SHCP was maintained. The intention of these changes was to impose a hard budget constraint on subnational governments while being consistent with a gradual move toward more autonomy. However, the effectiveness of the new framework will depend on how it is implemented. In particular, in order to ensure the credibility of the new framework, it will be important for the federal government to avoid any bailouts when and if the framework is put to the test. This risk has been reduced by the establishment of escrow accounts that use transfers from the federal government as collateral for the loans received by subnational governments.

15. The fiscal ROSC identified room for improvement in budgetary and reporting practices of states and municipalities. Deficiencies in data reporting and transparency are apparent in the time lag with which budget performance statistics of states are available in the IMF’s Government Finance Statistics (more than 18 months).

16. The federal government is leading a series of initiatives to improve budgetary systems, accounting practices and public reporting of fiscal information. A Committee of Secretaries of Finance of the states meets regularly with staff from the SHCP to coordinate initiatives and assess progress. In addition, to promote fiscal transparency at the subnational level, the SHCP requires that debt and fiscal statistics for the previous year be published and that the state is not in arrears with federal development banks in order to register new debt contracts. Improving fiscal statistics at the subnational level will be critical for the new regulations regarding subnational debt in order to allow fully informed credit assessments by market participants. The federal government will need to continue working closely with states on this front.

17. Subnational governments do not pose a significant risk to macroeconomic performance. Their relatively low level of indebtedness and their circumscribed financial autonomy has helped maintain fiscal stability. In addition, since the participaciones are fully linked to federal government tax revenue, these transfers will adjust automatically in the event of a revenue shortfall, forcing states to share the adjustment with the federal government.

D. Central Bank Operations

18. Monetary policy is conducted by an independent central bank. The Law of the Bank of Mexico (BOM) approved in 1993 establishes that the main monetary policy objective of the BOM is the preservation of the purchasing power of the peso and delineates the role and responsibilities of the central bank. Besides its role in conducting monetary policy, the BOM also regulates the foreign exchange and derivatives markets.

19. The BOM formally adopted an inflation targeting framework in 2001 in the context of a flexible exchange rate system⁵ and market determined interest rates. Under this framework, the BOM established a medium–term (2–3 years) inflation objective with well–defined annual targets consistent with this objective. The inflation targets refer to the end–year headline consumer price inflation. The medium–term objective was set at around 3 percent by end–2003, with intermediate targets of under 6.5 percent in 2001 and under 4.5 percent for 2002. In July 2002, the BOM formally established the 2003 inflation target at 3 percent and announced that from 2004 onwards it would be maintained at 3 percent with a band of ±1 percent around the midpoint. The target for 2001 was met with considerable margin, marking the third consecutive year in which the inflation objective of the BOM was met.

20. The Financial System Stability Assessment (FSSA) prepared in 2001 found that the observance of practices relating to the clarity of roles, responsibilities and objectives of the BOM for monetary policy, and to an open process for formulation and reporting monetary policy decisions, were well entrenched both in the legal and regulatory framework, and in practice. Accountability to the government and to congress is well established and there has been substantial progress in reporting to the public including through the quarterly inflation reports. Accountability to the public would be enhanced by a more detailed disclosure of the BOM’s financial statements and its general accounting practices and by reporting the main developments and oversight activities of the payments systems.

21. The FSSA found that roles and institutional mandates between the government and the BOM are generally well defined but the asymmetric treatment of the BOM profits and losses—whereby profits are transferred to the government while losses are assumed by the BOM—c ould erode the BOM’s capital, as occurred in 2001. While distribution of profits cannot take place if the distribution reduces its capital in relation to nominal GDP, this restriction is insufficient in the case the BOM incurs in operational losses.⁶ Also, the BOM is temporarily absorbing the implicit subsidies involved in the pre–1993 credits extended to public trust funds that it administers as well as losses from the write–off of loans granted to the Bank Savings Protection Fund (FOBAPROA) during the bank crisis. There is, however, a mandate to offset a pre–specified fraction of these expenditures against annual profits prior to transferring the residual to the government.

22. The BOM has begun to implement a plan to eliminate remaining credit risks in the payments systems, in line with its objective of complying with the BIS Core Principles for Systemically Important Payment Systems. In this regard, the BOM has announced to financial institutions a sequence of measures that will be introduced within the next three years. The first of these measures, which was introduced in February 2002, requires that any overdraft in the large value electronic payment system be settled in the same day by using bilateral credit lines provided by other banks. In the last quarter of 2002, additional measures will be introduced to improve the quality of collateral associated with the BOM’s credit, and to consolidate the intra–day credit into one payment system from the prevailing three. The BOM is also preparing a legislative proposal that will be presented in 2002 to clarify the bank’s legal mandate to supervise the payments system and to increase certainty of payments by eliminating the current practice by which payments could be reversed by court–order up to 270 days after they have taken place.

23. The BOM is a well–run institution with highly–qualified management and staff, that is carrying out its institutional mandate effectively in accordance with the law. Its credibility has improved considerably in recent years and the institution is respected and perceived by the public and the government as strong and capable and with good governance practices.

24. The BOM’s increased credibility and its conduct of monetary policy have clearly contributed to macroeconomic stability in recent years as evidenced by the decline in inflation and real interest rates. Furthermore, the BOM’s rapid adjustment of monetary policy in response to the Russian crisis (which induced an increase in interest rates of more than 25 percentage points at the height of the crisis) and its preventive measures in 2001–02, to address potential inflationary pressures notwithstanding a weak economy, are widely and correctly seen as proof of its commitment to price stability. These responses, supported by the flexible exchange rate regime, have also given market participants confidence that major external imbalances in the Mexican economy would not develop.

E. Financial Sector

25. The FSSA concluded that the financial system has improved its resilience to shocks in recent years and important progress has been made in the implementation of international standards and codes. As a result, the banking sector is not likely to pose systemic problems. Nevertheless, further actions were recommended to make the banking system more resilient to shocks and to achieve full observance of international standards.

26. Financial sector supervision has been significantly upgraded, with the National Banking and Securities Commission (CNBV) now having improved technical capacity to identify and monitor the risks taken by banks. New supervisory tools have been developed, and the information technology systems have been upgraded in order to conduct effective off–site examinations. Legislation enacted by congress in April 2001 enhanced further the supervisory powers of the CNBV through improving cross–border supervision; allowing it to establish regulations for financial conglomerates; and introducing a system of prompt corrective actions that will provide the authorities with adequate tools to deal with problem banks in a timely and transparent manner. The reforms also restricted related lending; improved corporate governance; provided an adequate legal structure for conducting internet banking operations; and provided an appropriate structure for the development of mutual funds.

27. The regulatory framework has been amended to comply with best international practices. Regulations have been introduced that limit ad hoc forbearance and require its full disclosure in bank’s audited financial statements; new rules for loan–portfolio classification; requirements on overall risk management practices; and rules on internal controls that resemble best international practices. In addition, a timetable is in effect through end–2002 to bring the Mexican definition of capital to international standards. In May 2002, modifications to banks’ capital requirements were introduced (in line with international standards) that are aimed at following–up on the 2001 financial reform. The new requirements also aim at reactivating credit in the housing sector and modifying the treatment of certain credit card operations.

28. Indicators of bank soundness have improved substantially. The banking sector has strengthened its capital base in the last three years, in part reflecting debt restructuring operations, as well as increased foreign participation. Practically all banks already meet the requirements of regulatory capital that will be in effect at the beginning of 2003. Broad–based lending to the private sector still needs to recover from recent lows in order to reinvigorate the financial intermediation role of banks, and to diversify their profits base by making them less dependent on income from holdings of government securities.

29. Stress simulations indicate that a scenario that combines a sharp slowdown in economic activity, a depreciation of the peso, and a rise in domestic interest rates would be detrimental to banking system capital and profitability. Although a depreciation of the peso would have a positive effect on banks’ net worth given the positive net foreign exchange position of the system, this would be more than offset by the effect of higher domestic interest rates on bank’s balance sheets and the rise in credit risk. However, given the large participation of strong foreign banks, the still low participation of banks in financial intermediation, and the recent strengthening of capital, the banking system should not pose a systemic risk to the Mexican economy.

30. A “Committee for Modernization,” led by the Deputy Secretary of Finance, and composed of senior officials of the relevant government agencies as well as key private sector participants has been established to set priorities and foster consensus for additional financial sector reforms in the wake of the recommendations made in the FSSA (see Chapter II for a discussion of these reforms).

31. Mexico was found to be in compliance with three out of the five international standards and codes covering the financial sector (transparency of monetary and financial policies, and standards and codes in the insurance and securities markets). Several deficiencies were found in compliance with the Basel Core Principles for effective bank supervision and the standards for payments systems. The authorities have developed an action plan—which is already being implemented—aimed at achieving compliance with international standards in these areas.

32. A remaining impediment to adherence of the Basel Core Principles concerns the fragmentation of powers and insufficient coordination across the various agencies responsible for bank supervision. In this regard, the “Committee for Modernization” has established a working group that is reviewing coordination among agencies; the division of labor on supervision matters among the relevant agencies; and issues related to the CNBV’s autonomy, accountability, and corporate governance. The regulatory framework was further amended last year by establishing minimum guidelines for banks’ internal controls; and harmonizing regulations of state–owned development banks with that of private banks.

33. An important vulnerability facing the banking system that was noted by the FSSA is the need for a proper exit strategy. The current system is heavily biased toward an open–bank resolution approach (whereby troubled banks are kept open during the restructuring process), which will become increasingly inconsistent with “a least cost resolution” strategy under the gradual elimination of universal deposit guarantee. To address this situation, the authorities intend to introduce a framework more consistent with a least–cost resolution approach, which would streamline all the phases of a resolution process, ranging from prompt corrective action to potential liquidation, open–bank assistance or purchase and assumption transactions. Draft legislation could be sent to congress in late 2002 or early 2003.