This Selected Issues paper assesses the potential financial vulnerabilities of the corporate sector in Mexico. It provides an overview of salient features of the Mexican corporate sector. The paper also presents the formal stress tests that estimate the potential effects of some macroeconomic and financial shocks, such as a sharp depreciation of the exchange rate, a sustained increase in interest rates, a slowdown in demand, and a prolonged international market closure on the corporate sector.


This Selected Issues paper assesses the potential financial vulnerabilities of the corporate sector in Mexico. It provides an overview of salient features of the Mexican corporate sector. The paper also presents the formal stress tests that estimate the potential effects of some macroeconomic and financial shocks, such as a sharp depreciation of the exchange rate, a sustained increase in interest rates, a slowdown in demand, and a prolonged international market closure on the corporate sector.

VI. Assessing Fiscal and External Sustainability: The Case of Mexico

A. Introduction

1. Assessing debt sustainability is of key importance in Fund surveillance. If a country finds itself in a situation where its debt—under reasonable assumptions—cannot be financed, a policy correction would be called for, independently whether this lack of sustainability derives from an insufficient market confidence (“liquidity”) or a lack of sufficient net income to service the debt in the long term (“solvency”).

2. While sustainability assessments have for some time been standard in Fund surveillance, the Executive Board recently called for introducing greater discipline and consistency in the staff assessments of fiscal and external sustainability. The approach, which is described in “Assessing Sustainability,” SM/02/166, is based on two main elements:

  • a detailed articulation of the staffs baseline medium–term scenario with clearly spelled–out assumptions and including a decomposition of the historical and projected debt dynamics; and

  • a standard set of sensitivity tests around the medium–term baseline scenario, examining the implications of alternative assumptions on debt dynamics.

The framework is, however, by no means considered exhaustive and can be usefully complemented by other types of tests such as specific adverse scenarios and/or short–term stress tests.

3. This chapter reports on the sustainability analysis that the staff has undertaken in the context of its surveillance work on Mexico. Section B contains a detailed description of the staffs baseline medium–term scenario and its debt dynamics as well as the standard sensitivity tests proposed in SM/02/166 for assessing external and public debt sustainability.

4. The standardized debt sensitivity analysis around the baseline scenario is complemented in Section C with a series of stylized stress tests of the potential short–term effect that a repeat of historical capital account crises would have on Mexico’s balance of payments. The main conclusions of both exercises are summarized in Section D.

B. Medium-Term Baseline Projections and Sensitivity Tests

5. This section presents detailed assumptions underlying the staffs baseline scenario. It also includes a set of stylized projections of the external and public debt based on historically observed averages and sensitivity tests analyzing the effects of variations in the underlying assumptions on the debt dynamics.

6. The staffs baseline scenario is predicated on partial implementation of the government’s structural reform agenda and assumes an average potential growth rate of 4¼ percent during 2002–07,1 a widening non–interest current account deficit and substantial inflows of foreign direct investment and other non–debt–creating flows. The domestic real interest rate is projected to be about 5 percent (compared with about 6.2 percent in 2001–02) and the implied external real interest rate averages 5¾ percent over the projection period.

7. In line with standard assumptions used for the World Economic Outlook, the real exchange rate is assumed to remain unchanged at its end–June 2002 level. The oil price evolves in line with futures prices until 2003 and remains unchanged thereafter, implying a 14 percent decline in nominal terms in the oil price over the projection period.

Fiscal debt projections

8. The fiscal baseline scenario is based on a passive revenue scenario (without tax reform) and the assumption that the authorities continue to adjust programmable expenditure in order to comply with their medium–term fiscal targets of reaching a surplus in the traditional budget definition of about ½ percent of GDP by 2006:2

  • The revenue elasticities of the VAT and the income tax with respect to GDP are assumed to be one. Nonrecurrent revenues are projected to decline from about 0.8 percent of GDP in 2002 to 0.2 percent of GDP a year on average for 2003–07 as privatizations taper off; revenue gains from improved tax administration are set at 0.1 percent of GDP a year during 2003–07.

  • The oil revenue projection is based on an export volume increase of 32 percent on the basis of planned investments by PEMEX (including through PIDIREGAS3) and in line with the authorities forecast.

  • On the expenditure side, wages are assumed to grow in line with nominal GDP. PIDIREGAS financing requirements are projected broadly in line with the authorities’ intentions.

9. The staffs baseline scenario implies a decline in the public–debt–to–GDP ratio of about 6 percentage points between 2002–07. The decomposition of the baseline debt dynamics is presented in Appendix Table I at the end of this chapter. The exercise shows that the decline in the public–debt–to–GDP ratio is supported by a 1½ percentage point of GDP improvement in the primary balance (Appendix Table I, line 6), while the interest cost of the debt (line 16) is to a large extent offset by the favorable effect of nominal GDP growth on the debt ratio (lines 17 and 18). The residual of the baseline decomposition is small and fully explained by valuation changes to the debt stock due to the exchange rate movements.

10. The robustness of the projected public debt dynamics was tested by applying to the baseline scenario the set of standardized sensitivity tests proposed in SM/02/166. The recalibration of the baseline paths of real GDP growth, the primary balance, the effective nominal interest rate4 and the growth rate of the GDP deflator in line with the averages of the past five years does not significantly alter the debt dynamics (Appendix Table I, line 20). At the end of the projection period, the public–debt–to–GDP ratio is about 3 percentage points of GDP lower than in the baseline. This is explained by the fact that that the baseline scenario assumptions are slightly lower (more conservative) than the historical averages for real GDP growth, augmented primary balances and nonrecurrent revenues (Table 1 below).

Table 1.

Mexico: Historical versus Baseline Scenario Parameters

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Source: Fund staff computations based on annual data from the Ministry of Finance and Public Credit (SHCP).

Effective nominal interest rate deflated by GDP deflator growth.

11. The standardized sensitivity tests set out in SM/02/166 consider the application of two–standard–deviation shocks to the historical averages of each of effective nominal interest rate, real GDP growth, GDP deflator and augmented primary balance during the first two years of the projection period, while maintaining baseline assumptions for all other parameters. However, a number of pilot exercises (including Mexico) have shown that an isolated shock to the effective nominal interest rate may result in the simulation of real interest rate shocks that are unrealistically large.5 To overcome this problem the staff replaced the nominal interest rate shock with a two–standard–deviation shock to the effective real interest rate.6

12. Figure 1 shows the results from this exercise. The debt–to–GDP ratio would suffer most from isolated negative shocks to the effective real interest rate (Appendix Table I, line 21) and real GDP growth (line 22). Two–standard–deviation shocks (for two years) to these variables would lead to an increase in the debt–to–GDP ratio of around 4 percentage points over the baseline projection.

Figure 1.
Figure 1.

Sensitivity of Gross Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 238; 10.5089/9781451825619.002.A006

Note: Effect of negative two-standard-deviation shocks on the effective real interest rate, real GDP growth, GDP deflator growth, and the augmented primary deficit on baseline medium-term debt dynamics.

13. If the negative shocks to the effective real interest rate, real GDP growth and the augmented primary balance were to occur simultaneously, the public debt–to–GDP ratio would suffer more significant increases (Appendix Table I, lines 25 and 26). However, the debt dynamics would still turn around once the impact of the shocks fades. The same is true for a one time 10 percentage point of GDP increase in the debt ratio (line 28), which is intended to simulate the hypothetical materialization of contingent liabilities of the public sector.

14. The stress tests presented in this section assume unchanged fiscal policies in reaction to adverse shocks. However, as noted in Chapter V of the Selected Issues, the Mexican authorities have a solid track record of adjusting public expenditure in response to adverse developments. If the simulated shocks were to materialize, such adjustments would improve the primary balance and could offset part of the upward pressure on the debt–to–GDP ratio. In addition, the methodology of the stress test exercise is not suited to capture a number of changes to the structure of Mexico’s public debt, which have reduced vulnerability in recent years. These include, for example, the lengthening of the average maturity of the public debt stock and the broadening of the investors base to include a larger proportion of high grade investors.

External debt projections

15. As noted above, the baseline scenario is based on the assumption of a moderate implementation of the planned reforms and the continuation of the current stability–oriented macroeconomic policies. Mexico is, thus, expected to continue to attract foreign direct investment and equity based portfolio investment (about 70 percent of the external current account deficit and 2½ percent of GDP); the country risk premium is expected to stay low (about 200 basis points); and the non–interest current account deficit is expected to widen to about 1½ percent of GDP, reflecting a sustained demand for capital goods and a relative high level of the real exchange rate. The assumptions underlying the baseline scenario are spelled out in the lower part of Appendix Table II and in Table 2.

Table 2.

Mexico: Historical versus Baseline Scenario Parameters

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

16. It was, moreover, assumed that Mexican goods will continue to gain market shares in world markets, particularly in the United States, as the increased capital stock and structural reform translates into higher relative productivity growth and economic integration is deepened. After an initial period when imports of goods and services are expected to exceed exports of goods and services, exports and imports are expected to expand by about the same amount, with imports of capital goods remaining dominant throughout the period. Family remittances of U.S. based Mexican workers—which constituted about 70 percent of oil exports in 2001—are expected to remain about constant at 1½ percent of GDP.

17. As can be seen from Appendix Table II, after an initial small increase in 2002 and 2003, the baseline projection implies a modest reduction in the external (public and private) debt–to–GDP–ratio to below 27 percent in 2007. The decomposition of the change in the debt ratio shows that this profile largely reflects a negative contribution to external indebtedness from the high non–debt–creating flows (mainly foreign direct investment) amounting to about 2 ½ percent of GDP throughout the projection period (line 5), exceeding the non–interest current account deficit by about 1 percent of GDP a year (line 4).

18. The standard sensitivity tests performed in Appendix Table II reveal that the baseline external debt projection is quite sensitive to assumptions on the size of the primary current account deficit, non–debt–creating inflows, the level of the interest rate, the real growth rate, and the GDP deflator in U.S. dollar terms (heavily affected by changes in the real exchange rate). Using five–year historical average values of the above parameters would, however, result in an even more rapid reduction in the ratio of external debt to GDP. The rapid decrease in the external debt to GDP ratio mainly reflects the historical high level of non–debt–creating inflows and low primary current account deficit (see Table 2).

19. The set of sensitivity tests shows that in none of the analyzed cases, the external debt–to–GDP ratio would increase beyond 40 percent. The most pronounced increase in the debt ratio would occur if the GDP deflator were to experience a one–time decrease of 30 percent, reflecting, for example, a sharp real devaluation of the peso (which were not accompanied by a reduction in the projected current account deficit).7 In this case the debt–to–GDP–ratio would peak at about 36 percent in the year of the depreciation, followed by a gradual reduction to about 33 percent of GDP. A smaller, but still significant increase would be experienced in the case of a simultaneous one–standard–deviation shock to all of the parameters lasting for two years (line 17).

C. Stress Test Based on a Repeat of Historical Capital Account Crises

20. In order to complement the medium–term debt projections presented above, the staff prepared a set of stress tests based on a stylized replay of previous capital account crises, notably the 1995 Mexico crisis (the “Tequila crisis”), the 1998 Russia crisis, and the 1999 Brazil crisis. These tests attempt to evaluate the size of a potential balance of payments financing gap if the above crises were to reoccur.

Historical crisis: key features

21. The historical episodes that were used as a basis for the stress test simulations can be broadly separated into two groups: the Russia and Brazil crises, on the one hand, and the Mexico 1995 crisis on the other. While the Brazil and Russia crises were examples of relatively pure financial market contagion, the “Tequila crisis” was triggered mainly by inappropriate domestic policies.

22. Mexico’s 1995 crisis stands out as the most severe in terms of the response of domestic interest rates and the exchange rate: domestic short–term interest rates peaked at 84.6 percent (an absolute increase of 7,000 basis points) and the exchange rate collapsed by more than 50 percent associated with the abandonment of the currency band (Table 3). The response of interest rates and the exchange rate was also significant during the Russia crisis when domestic interest rates reached a maximum of 46 percent (an increase of 2,400 basis points), and the peso depreciated by 16 percent at the peak of the crisis. During the Brazil crisis, the increase in domestic interest rates was also significant (2,800 basis points), but the peso only depreciated by 8 percent. As shown in Figure 2 the Mexico crisis had also the largest effect on external bond spreads.

Table 3.

Stress Test Scenario Assumption

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Source: Bank of Mexico; and Fund staff estimates.
Figure 2.
Figure 2.

Mexican Sovereign Spread and IMF Contagion Index 1/

Citation: IMF Staff Country Reports 2002, 238; 10.5089/9781451825619.002.A006

Sources: J.P. Morgan and Fund staff estimates for Contagion Index.

23. According to balance of payments data, residents’ assets abroad as well as errors and omissions did not show any clear sign of substantial resident “capital flight” (in terms of an increase in residents holdings of foreign assets) in any of the crises. This could reflect data problems but also the fact that private agents behavior was positively affected by the anticipation of large international support (Mexico 1995) or the drawdown of private contingent credit lines (Russia). Significant portfolio outflows were, however, recorded, in particular in the case of the Mexico 1995 crisis, which mostly reflected nonresidents’ reduction in their Mexican exposure as they, in part, refused to rollover maturing dollar–denominated domestic debt.

The balance of payments gap

24. The balance of payments stress test proceeded in two steps. First, a “financing gap” was estimated on the basis of assumptions of, amongst other things, reduced market access, unchanged external current account deficit, and no change in international reserves. Thereafter, the estimated “financing gap” was compared to the size of international reserves or what may be considered as a reasonable adjustment in the current account, either as a result of a deprecation of the exchange rate or contraction in domestic demand (e.g., fiscally induced). It should be noted here that the calculation of the financing gap takes the current account deficit and the size of international reserves as a given only because these variables are considered as adjustment variables. Admittedly, this appears a bit artificial since, in the real world, of course, all these things happen simultaneously and are jointly determined. The separation in two distinct steps is, however, a reasonable way to proceed in the case of relatively pure capital account shocks of the contagion type, which appear to be more of a quantity rationing phenomenon than based on considerations of marginal costs and values (e.g., the availability of finance as measured by rollover rates etc. is not considered to be very sensitive to a change in the exchange rate).

25. It should be noted, nevertheless, that the estimated financing gap is not fully independent of policy actions. The observed rollover rates, foreign direct investment, portfolio flows, as well as exchange rate and interest rate developments are to a large extent a result of the policy actions that were taken during the crisis periods, in terms of macroeconomic or structural policies. Thus, by basing our simulations on historical observed availability of external finance, we implicitly assume that the current administration will be in a position to take similar policy action as the former administration did during the observed crises.

26. Besides the technical assumption of a current account deficit at its baseline level, the unchanged exchange rate, and no change in reserves, the quantitative simulations of the potential external financing gap were based on the following assumptions:

  • Bond and loan rollover rates were assumed to be equal to the ones observed in the crisis;

  • Portfolio outflows were assumed to be equal to the outflows experienced during the historical crises in percent of the stock of foreign holdings of Mexican assets;

  • Foreign direct investment was assumed to fall by the same amount in percentage terms in relation to the baseline scenario as observed in these crises; and

  • No domestic capital flight (measured as sharp increase in residents holding of foreign assets) was assumed since there is no clear evidence of such flight in the historical data.

27. Based on the above assumptions together with estimates of the gross financing need over the three quarters from mid–2002, the staff estimated that the potential financing gap would vary between US$3 billion in the case of a replay of the Brazil 1999 crisis and US$16 billion in the case of a replay of Mexico 1995 (Table 4). Although a large part of this adjustment could be taken by contracting the current account deficit through a combination of fiscal contraction and exchange rate depreciation, some reduction in international reserves would seem necessary. This should, however, not cause any concern since in all of the cases the estimated financing does not exceed 50 percent of total international reserves.

Table 4.

Mexico: Sources of the BOP Gap

(In U.S. million, three quarters)

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Source: Bank of Mexico; and Fund staff estimates.

28. Although apparently not a salient feature in the historical crises, resident capital flight is possible and may be underestimated in the historical data. More than half of the outstanding stock of liquid assets amounting to about US$58 billion (sight deposits plus government securities not held by pension funds) would, however, need to move into foreign assets in order to fully deplete the central bank of Mexico’s international reserves.

D. Conclusions

29. The staffs vulnerability assessment shows that the baseline medium–term external and public debt–to–GDP dynamics are relatively robust to alternative assumptions about the underlying macroeconomic variables. Reverting to historical values for these variables instead of the assumptions in the baseline would not lead to very significant changes in the projected debt levels in the medium term.

30. Additional temporary negative shocks on the underlying macroeconomic variables would lead to some increases in the level of public and external debt. The sensitivity analysis shows that a combination of slower economic growth and higher interest rates would result in an increase in both the overall public sector and external debt to GDP ratios. However, even with the most severe shocks that were simulated both public and external debt ratios would return on a declining trend once conditions return to the baseline state.

31. Stress tests of the potential financing gap arising from a sharp reduction in external finance in line with earlier capital account crisis suggest that the potential financing gap, in the absence of major resident capital flight, could relatively easily be financed by the use of international reserves and other supportive policies. Moreover, more than half the amount of non–institutional holdings of liquid assets would have to switch abroad to create capital flight of a magnitude sufficiently large to fully deplete international reserves.

Appendix Table I

Mexico: Public Sector Debt Sustainability Analysis

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Sources: Ministry of Finance and Public Credit (SHCP); Bank of Mexico; and Fund staff estimates.

Negative value indicates surplus.

Budgetary revenue excluding nonrecurrent income, capital gains on debt buy–backs and premia on par bonds.

Budgetary expenditure + PIDIREGAS financing requirement + IPAB financing requirement+ FARAC financing requirement + development banks financing requirement + inflation component of indexed bonds + reserves of IMSS and ISSSTE + debtor support programs.

Budgetary financing cost + accrued interest IPAB + net interest PIDIREGAS + inflation component of indexed bonds + FARAC financing requirement + debtor support programs.

Projection assumes a constant residual at the baseline level.

Symbols: i=effective nominal interest rate; g=real GDP growth rate; p=growth rate of GDP deflator; D=debt–to–GDP ratio; year t=2002; year t+1=2003.
Appendix Table II

Mexico: External Debt Sustainability Analysis

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Sources: Bank of Mexico; and Fund staff estimates.

All variables relative to baseline, except the US dollar GDP deflator which is set at zero, as further real appreciation of the peso is considered an unlikely event.

This projection implicitely assumes zero foreign assets accumulation (e.g., increase in international reserves).


The average annual growth rate was 4¾ percent during 1997–2001 and 3¼ percent during 1991–2001.


Implying a net PSBR of less than 2 percent of GDP.


PIDIREGAS are public investment projects financed and executed by the private sector with deferred budgetary impact.


The effective nominal interest rate is obtained by dividing the total annual interest cost of the public sector debt by the total stock of public debt at the end of the previous year.


This problem is particularly acute in countries where nominal interest rates have experienced a sharp downward trend in recent years (e.g., because of rapid disinflation), as has been the case in Mexico, Brazil, and to some extent, Turkey.


Because effective real interest rates were relatively low ex post in the mid/late 1990s– probably due to the still relatively high inflation–the staff constructed the two–standard–deviation shock relative to the variable’s baseline value instead of its historical average.


This shock is a standard shock that may not be very relevant in the case of Mexico as a 30 percent devaluation should result in a significant increase in the peso value of oil exports, which–unless offset by a similar increase in domestic absorption–should result in a durable reduction in the current account deficit.

Mexico: Selected Issues
Author: International Monetary Fund