Mexico: Staff Report for the 2004 Article IV Consultation

This 2004 Article IV Consultation highlights that economic activity in Mexico accelerated to 3.8 percent in the first half of 2004 over the previous year. This recovery is partly attributable to strengthening U.S. industrial production, as reflected in growth in Mexican manufactured exports of 10½ percent (seasonally adjusted) in the first seven months of 2004 over the same period in 2003. The government has made significant progress in strengthening the structure of public debt. Several liability management operations have helped to improve the efficiency of the yield curve.


This 2004 Article IV Consultation highlights that economic activity in Mexico accelerated to 3.8 percent in the first half of 2004 over the previous year. This recovery is partly attributable to strengthening U.S. industrial production, as reflected in growth in Mexican manufactured exports of 10½ percent (seasonally adjusted) in the first seven months of 2004 over the same period in 2003. The government has made significant progress in strengthening the structure of public debt. Several liability management operations have helped to improve the efficiency of the yield curve.

I. Overview and Key Issues

1. Mexico is experiencing a broad-based economic recovery following three years of weak activity (Text Table 1). Both private and official growth estimates for 2004 have risen steadily since the beginning of the year to stand at around 4 percent by mid-year. The pick up in activity has been associated with the U.S. economic recovery, and in particular the impact on Mexican exports of the strong upturn in U.S. manufacturing activity beginning in the second half of 2003. In addition, growth in Mexican final domestic demand has accelerated to 4 percent in the first half of 2004 over the same period in 2003. Along with a continuing expansion of private consumption and residential construction, activity has been boosted by a recovery in business fixed investment, following a decline of 15 percent from the peak in 2000 through 2003.

Text Table 1.

Mexico: Growth of Real GDP by Component (1993 prices)

(4-quarter percentage change, unless otherwise indicated)

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Source: Authorities and Fund staff estimates and projections.

2. While the near-term growth outlook is favorable, important policy challenges remain. Political fragmentation since congressional elections in July 2003 has blocked legislative initiatives, and most observers believe it unlikely that major actions will be possible before the 2006 elections. Absent further progress on structural reforms, prospects for robust economic growth beyond 2004 have become less favorable. In the fiscal area, markets have been reassured by the government’s ability to meet its objectives for the traditional deficit, despite spending pressures, and the public debt structure has been strengthened further. Yet the spending of “windfall” oil revenues in recent years has made the fiscal position more vulnerable to a decline in oil prices. Even if oil prices do not decline sharply, significant spending compression will be needed to meet medium-term budget targets in the absence of tax measures that would boost non-oil revenues. Public debt edged up in 2003, largely reflecting exchange rate depreciation, leaving gross public debt at around 51 percent of GDP compared with 47¾ percent in 2001.

3. Inflation has been brought down to the low single-digit range. More recently, however, headline inflation has risen above the upper bound of the Bank of Mexico’s (BOM) 2-4 percent “variability interval.” While supply shocks have played an important role in boosting headline inflation, core inflation has been resistant to further declines, stabilizing in a range around 3½ percent, while expectations of headline inflation over the next 12 months have edged up to over 4 percent. The main challenge is to maintain the credibility of the BOM’s commitment to reducing inflation to 3 percent, while not choking off the nascent recovery.

4. The Fund’s policy advice to Mexico has focused on the need to consolidate further the broad fiscal position, lower inflation to the medium-term target, advance structural and financial reforms, and promote measures to crisis-proof the economy. Progress in several of these areas has been impressive, notably in lowering inflation, modernizing the financial system, allowing the exchange rate to float freely, meeting targets for the traditional fiscal deficit, and strengthening the structure of public debt. Mexico has participated in an FSAP, and was the first major emerging market country to issue bonds with collective action clauses (CACs) in 2003. On the other hand, after successes in the latter half of the 1990s, recent progress in fiscal consolidation is mostly due to higher oil prices, and structural reforms have been limited (Box 1). The authorities broadly share the Fund’s views on the priorities in these areas, but political constraints have hindered passage of necessary legislation, as it has been difficult to channel the longer-term benefits of these policies into broad popular support.

5. Against this background, the 2004 consultation focused on the following issues:

  • Fiscal policy. Success in meeting deficit targets has recently been aided by windfall oil revenues. Moving ahead, staff emphasized the need to save a significant portion of future windfalls to avoid increasing dependence of the budget on oil revenues. The authorities agreed, but noted the political difficulties in resisting spending pressures when revenues were strong—at the same time, they underscored Mexico’s demonstrated ability to cut spending if needed to meet deficit targets. Staff observed that, even if oil prices did not fall sharply, meeting medium-term fiscal targets would be challenging without measures to boost non-oil revenues. The authorities agreed that, in such a case, significant further spending restraint would be needed.

  • Monetary policy. Staff noted that monetary conditions remained relatively easy, due in part to peso weakness, and agreed with the authorities that, with headline inflation remaining above the BOM’s target, tightening would be appropriate. The magnitude and timing, however, would depend on an ongoing assessment of the impact of supply shocks on underlying inflationary pressures, and also that of external monetary actions on domestic markets. Staff noted the problems in communicating policies when inflation was above target, and suggested that publication of an official inflation forecast could help in this regard. The BOM observed that further refinements to the inflation targeting framework would be considered in due course. It was premature, however, to consider publishing an inflation forecast, particularly given the indirect relationship between existing monetary instruments and market conditions, as well as uncertainties about the inflation outlook.

  • Structural reforms. Discussions focused on: the prospects for reviving the reform agenda; smaller-scale reforms that might be politically feasible and/or did not require legislation; and the effects of a lack of reforms on the medium-term outlook. The authorities were optimistic that tax and pension reforms proposed by the National Fiscal Convention had a greater chance of success than previous initiatives; the passage of fiscal responsibility legislation was also possible in the fall session of congress. In contrast, there was no public consensus for further reforms in the energy sector. Staff noted that liberalization of the telecommunications sector could have a catalytic effect on growth; it could also be accomplished by executive action as opposed to legislation.

  • Competitiveness. Discussions focused on concerns about a possible loss of competitiveness in U.S. markets. The authorities pointed to several industry-specific factors that explained the stagnation of Mexico’s market share in recent years, and saw the recent recovery in the maquiladora sector as a sign of renewed confidence in Mexico’s prospects. There was general agreement, however, that Mexico would need to take active measures to keep pace with other fast-growing emerging market countries in export markets.

Mexico: The Administration’s Structural Reform Agenda, 2002–061

  • 1. Energy sector reform aimed to increase the efficiency of public producers and allow broader private sector participation. The latter is needed both to acquire needed expertise, as well as to expand capital investment. The constitution, however, bars most private-sector participation in this sector.

    Status: The government has taken incremental steps to expand private participation. In 2002, PEMEX introduced multiple service contracts, which allow private firms some operational responsibilities in gas fields. While a limited degree of private investment is allowed in electricity generation, only state companies can distribute power. No changes have occurred in the oil sector. At this stage, constitutional changes in the energy area appear highly unlikely, and the administration is focusing on establishing legal certainty for the agreements already in place.

  • 2. Labor market reform aimed to increase productivity and employment in the formal sector by reducing rigidities. The objectives of the reform were to: lower sizable nonwage and dismissal costs; make work hours and probation periods more flexible; and improve union governance.

    Status: A reform was submitted to congress in 2002 based on a consensus between employers, unions, and the Labor Secretariat. In any case, it did not address major rigidities to hiring in Mexico, notably high nonwage and dismissal costs. The authorities still envisage a reform that would allow for, inter alia, more flexible work arrangements, and would facilitate the transfer of workers from the informal to the formal sector. Observers believe, however, that the current proposal may be too watered down to meaningfully increase flexibility.

  • 3. Telecommunications reform was intended to: increase coverage and quality of services; lower costs; promote a competitive environment; and encourage new technologies and services. Telmex controls 96 percent of the fixed-line network and its sister company, Telcel, controls 80 percent of the mobile market. Internet penetration is limited by a lack of fixed-line capacity.

    Status: The government and a congressional commission began working on a bill in 2002 that would strengthen regulatory authority; spectrum planning and administration; concessions and permits; satellite services; dominant carrier regulation; consumer protection; and fines. No significant progress has been made, however. In late 2003, the government announced plans to give COFETEL greater regulatory powers to boost competition. In March 2004 the WTO ruled that Telmex’s sole authority to set domestic connection charges breached its obligations under the WTO services agreement.

  • 4. Financial market reform aimed to promote savings, modernize the financial system to reactivate bank lending, deepen capital markets, and modernize development banks.

    Status: Congress passed several measures designed to achieve the authorities’ objectives, including legislation on credit guarantees, bank supervision, and the payments system. The closure of government banks and the sale of government shares in private banks has reduced government participation in the sector. Foreign ownership of banks and nonbank financial intermeidation have increased significantly, and oversight of banks has strengthened.

  • 5. Judical reform aimed to strengthen governance by improving the quality of public administration through improving the legal and regulatory framework, reducing corruption, and increasing the accountability of civil servants.

    Status: A number of initiatives have been sent to congress, and a law enabling public access to government information was approved in April 2002. Legislation improving corporate governance and protecting minority shareholder rights has also been enacted. In 2003, legislation protecting creditor rights was approved.

1 Source: “Plan Nacional de Desarollo, 2001–2006,” Government of Mexico, 2002.

II. Recent Economic Developments

6. Economic activity started picking up in late 2003 (Figure 1; Table 1). Following real GDP growth of only 1.3 percent in 2003, growth accelerated to 3.8 percent in the first half of 2004 over the previous year. This recovery is partly attributable to strengthening U.S. industrial production, as reflected in growth in Mexican manufactured exports of 10½ percent in the first seven months of 2004 over the same period in 2003. Consumption growth has also increased in response to lower interest rates and rising credit availability. Spurred by the recovery in exports and strong domestic sales, business investment began to pick up in late 2003, with gross private fixed investment rising by 5½ percent in the first half of 2004 over the previous year.

Figure 1.
Figure 1.

Mexico: Real Sector Developments

Citation: IMF Staff Country Reports 2004, 419; 10.5089/9781451825633.002.A001

Sources: Mexican authorities, U.S. Federal Reserve, and Fund staff estimates.
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.

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

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

7. The broad-based recovery has led to rising capacity utilization and higher employment. Capacity utilization in manufacturing has recovered above mid-2001 levels, while the staff’s estimate of the output gap has narrowed to slightly below 2 percent of GDP.1 Formal employment in the private sector increased by 185,000 in the first half of 2004, reaching its highest level since mid-2001; most of the increase is accounted for by permanent employment. The seasonally adjusted unemployment rate edged down to 3.7 percent in July after peaking at 3.9 percent in February.

8. Headline CPI inflation reached a record low of just under 4 percent at end-2003 (12-month basis), but rose above the BOM’s variability interval of 2-4 percent in early 2004 (Figure 2). Inflation has been boosted by supply shocks, including a temporary suspension of some meat imports from the United States, as well as increases in administered prices. As a result, the headline measure rose to 4.8 percent in August (12-month basis). Core inflation was lower, at 3.7 percent, but has shown no signs of decelerating since early 2003. Inflation expectations for the next 12 months stood at 4.1 percent in August. Contractual wage settlements averaged 4.5 percent in the first eight months of 2004, broadly unchanged from the second half of 2003.

Figure 2.
Figure 2.

Mexico: Inflation and Monetary Policy

Citation: IMF Staff Country Reports 2004, 419; 10.5089/9781451825633.002.A001

Sources: Mexican authorities, and IMF staff estimates.

9. The BOM has tightened policy five times since the beginning of 2004 via increases in the corto (the borrowed reserves objective) (Figure 2). In addition, domestic market conditions have been affected by two increases in the U.S. federal funds target rate. Starting in May—around the time the BOM streamlined its monthly press statement to more clearly communicate its views to markets—day-to-day volatility in the overnight inter-bank (fondeo) interest rate declined markedly. The fondeo has also responded more systematically to domestic and U.S. policy actions since May. In the event, it rose from an average of just over 5 percent in the second half of 2003 to slightly over 7 percent by mid-September 2004. Long-term interest rates rose by a similar amount over this period, with the 10-year government bond yield increasing from about 8½ percent in January to just over 10½ percent in September.


Overnight Bank Funding Rate (Fondeo)

Citation: IMF Staff Country Reports 2004, 419; 10.5089/9781451825633.002.A001

Source: Bank of Mexico

10. Nevertheless, monetary conditions remain relatively easy, due in part to weakness in the peso (Figures 2 and 3). After falling by 7½ percent against the U.S. dollar through 2003, the peso depreciated by a further 3 percent through mid-September, partly reflecting concerns about the effects of U.S. monetary tightening on emerging markets. The real effective exchange rate depreciated by 13 percent through 2003, and a further 1 percent in the first seven months of 2004. The weakness of the peso in 2003, combined with a drop in real short-term interest rates through the year of about 2½ percentage points, led to a significant easing in monetary conditions. Part of this easing has been reversed by rising interest rates in 2004, but monetary conditions remain substantially more accommodative than at the beginning of 2003.

Figure 3.
Figure 3.

Mexico: Financial Market Developments

Citation: IMF Staff Country Reports 2004, 419; 10.5089/9781451825633.002.A001

Sources: Mexican authorities, and Fund staff estimates.

11. Fiscal consolidation was modest in 2003, despite higher-than-budgeted oil prices (Figure 4 and Table 2). The augmented deficit fell slightly to 3 percent of GDP from 3¼ percent in 2002, primarily because of lower off-budget financing requirements arising from falling interest rates.2 The traditional deficit, at ½ percent of GDP, was broadly in line with the 2003 budget target and the 2002 outturn.3 Windfall gains from higher oil revenues and public enterprise profits were used to offset shortfalls in non-oil tax revenues and finance higher-than-budgeted capital outlays, wages, severance payments, and interest charges. As a result, the non-oil augmented deficit deteriorated further, reaching 9½ percent of GDP in 2003 compared with 8 percent in 2002. A small contribution of 0.1 percent of GDP was made to the Oil Stabilization Fund (OSF). In the first seven months of 2004, higher oil prices led to total revenue growth of 9 percent over the same period in 2003, while overall spending grew by 7 percent. Programmable current spending also rose by 7 percent, compared with the budget assumption of no nominal increase for the year as a whole.

Figure 4.
Figure 4.

Mexico: Fiscal Sector

Citation: IMF Staff Country Reports 2004, 419; 10.5089/9781451825633.002.A001

Sources: Mexican authorities, and Fund staff estimates.1/ Augmented balance excluding oil revenue (oil extraction rights, PEMEX net income, oil excess return levies, IEPS on gasoline) and PEMEX operational expenditure.2/ Assumes constant non-oil tax revenues and primary spending in relation to GDP (except for public sector energy costs).
Table 2.

Mexico: Financial Operations of the Public Sector

(In percent of GDP)

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Sources: Mexican authorities; and IMF staff estimates.

Includes MEX$11billion (0.2 percent of GDP) in 2002 and Mex$8 billion (0.1 percent of GDP) in 2003 in nonrecurring revenues taken from unclaimed pension provisions.

For 2003 includes MEX$6 billion, or 0.1 percent of GDP, in additional outlays for the voluntary separation program.

For 2002 includes MEX$49 billion, or 0.8 percent of GDP, in transfers to development banks associated with the cost of closing Banrural. For 2003 includes MEX$30 billion, or 0.5 percent of GDP, in projected infrastructure outlays and transfers to the Oil Stabilization Fund on account of higher-than-prorammed revenues, as well as MEX$9 billion for the capitalization of BANOBRAS.

Also includes transfers to IPAB and the debtor support programs

Includes a reduction in the net financial requirements of development banks of MEX$49 billion, or 0.8 percent of GDP, in 2002effectively offsetting the effect of closing Banrural on the overall PSBR.

Treats transfers to IPAB as interest payments.

Revenue excludes oil export revenue and nonrecurrent income. Expenditure excludes interest payments and the financial requirements of development banks.

Excludes oil revenue (oil extraction rights, PEMEX net income, oil excess return levies, IEPS on gasoline) and PEMEX operational expenditure.

Total tax revenue excluding IEPS on gasoline.

Excludes Banrural spending in 2002.

12. Public debt edged up further in 2003, but its structure continued to improve. The ratio of gross augmented public debt to GDP rose by 1¼ percentage point in 2003 to reach 51 percent, largely due to peso depreciation. The authorities have already completed their external financing program for 2004 on favorable terms. Several liability management operations, including an exchange of global bonds in early 2004, have helped to improve the efficiency of the yield curve. Domestic public debt management has concentrated on extending maturities, improving the liquidity of benchmark issues, and deepening domestic financial markets.4

13. In July, banks and the government agreed on the exchange of FOBAPROA debt for new bonds, ending a long period of uncertainty for the financial system. FOBAPROA notes were issued to banks after the 1994-95 financial crisis, but the government’s ultimate liability remained in dispute as their maturity approached in 2005-06. Of the original gross amount of about 3¼ percent of GDP, it is tentatively estimated that banks will receive about 1½ percent of GDP in new bonds issued by the deposit insurance agency (IPAB), with the difference reflecting recovered loans, loss sharing covered by banks, and related credits banks will pay.

14. Indicators of external vulnerability remain favorable. The current account deficit narrowed to 1½ percent of GDP in 2003, and was more than matched by FDI inflows (Figure 5; Tables 3 and 4). Net international reserves rose to US$58.2 billion at end-July 2004 from US$48 billion at end-2002, reflecting strong PEMEX receipts. Gross reserves at end-August are estimated at 170 percent of short-term external debt by residual maturity. After a short-lived spike to 250 basis points in mid-May as U.S. interest rates rose, Mexico’s EMBI+ spread had fallen back below 200 basis points by end-August.

Figure 5.
Figure 5.

Mexico: External Sector

Citation: IMF Staff Country Reports 2004, 419; 10.5089/9781451825633.002.A001

Sources: Mexican authorities, and Fund staff estimates.1/ FDI excludes the US$12.5 billion Citibank acquisition of Banamex in 2001Q3 and the US$4 billion BBVA acquisition of Bacomer in 2004Q1.
Table 3.

Mexico: Summary Balance of Payments, 2002–09

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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.

Includes financing of PIDIREGAS.

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

Excludes balances under bilateral payments accounts.

Short-term debt excludes pre-payments of public sector debt.

The financing requirement excludes pre-payments of public sector debt and reserve accumulation.

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.

Does not include loans associated with FOBAPROA/IPAB debt-restructuring programs.

Increase = appreciation.

In U.S. dollar terms net of maquila.

Includes development banks. Excludes PIDIREGAS which at end-2001were equivalent to $18 billion (2.9 percent of GDP).

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

Table 5.

Mexico: Summary Operations of the Financial System

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

From January 1997 onwards, monetary aggregates are based on resident financial institutions, and deposits of the public sector.

For 2004, actual data through June.

15. Larger corporates have taken steps to improve their debt structure by issuing peso-denominated fixed-rate debt in local capital markets. Small- and medium-sized firms continue to face difficulties in obtaining bank credit and market financing, while large companies in good financial health (mainly exporters) have relatively easy financing conditions. While there have been bond defaults and financial difficulties in a few enterprises, the authorities and market participants attribute these to problems in individual firms as opposed to systemic factors.

16. The authorities modified the mechanism for auctioning international reserves in March 2004. The BOM continues to pre-announce the amount of dollars to be sold in the market, equal to 50 percent of net reserve accumulation in the previous 3-month period. The sales will now, however, be spread over the following 12 months, as opposed to 3 months, to reduce volatility in the foreign exchange market.

III. Economic Outlook

17. The staff growth projection for 2004 has been revised up to 4 percent from 3½ percent in the April WEO.5 Economic recovery is expected to continue in the second half of the year, albeit at a more moderate pace than in the first half. Although U.S. forecasts have edged down recently, most still call for growth of around 4¼ percent this year. Recent domestic indicators, notably for exports, industrial production, and employment, also point to continued expansion. The impact of higher interest rates on spending is expected to be modest given improved corporate balance sheets and increasing credit availability to households and businesses, while exporters will continue to benefit from the past weakening in the peso.

18. CPI inflation is expected to remain above the 4 percent upper bound of the BOM’s variability interval in the near term. Shocks to agricultural prices have persisted and fed through to processed food prices, while administered prices have continued to rise quickly; in addition, the pass-through of peso depreciation and higher oil prices is still being felt. The staff’s projection calls for an inflation rate of 4.3 percent (12-month basis) by end-2004, consistent with both the consensus forecast and the projection produced by the staff’s structural model of wage-price dynamics.


Actual and Forecast Inflation, 2002–04

(In percent)

Citation: IMF Staff Country Reports 2004, 419; 10.5089/9781451825633.002.A001

Source: Bank of Mexico and Fund staff estimates.

19. Staff believes that the risks to near-term growth are roughly balanced. Given the low starting point for business investment, a sustained increase in private-sector confidence could well lead to a more powerful rebound than the 5 percent private fixed investment growth currently projected. On the external side, the recent turnaround in the maquiladora sector could signal a reversal of Mexico’s loss of U.S. market share, reflecting both the recovery in U.S. industrial production and the weakness of the peso versus the dollar. On the downside, a continuing political stalemate could dampen confidence. In addition, recent U.S. indicators have been mixed, and Mexico would be particularly vulnerable to a renewed downturn in U.S. manufacturing activity. The balance of risks to the near-term inflation outlook could be slightly on the upside given the trends in the recent data, although it is too early to judge the full impact of monetary tightening on actual and expected inflation.

20. Medium-term growth prospects are clouded by the stalled reform process. Staff has revised down its baseline projection for GDP growth over the 2005–09 period to an annual average of slightly over 3 percent, assuming the absence of significant reforms (Text Table 2). Even this performance is estimated to require trend total factor productivity growth of about ½ percent per year, above the average pace since 1980, but below that in the 1960s and 1970s (Box 2). Staff has also constructed a more optimistic scenario in which medium-term growth averages 4½ percent, and a downside scenario with growth of slightly over 2 percent. In discussing these projections with the authorities, staff acknowledged the considerable uncertainty attached to any such calculations. Estimates of both output gaps and potential growth were subject to large revisions in the face of actual developments, and the pace and impact of structural reforms was hard to judge. With these uncertainties in mind, staff advocated caution in forecasting medium-term growth to undercore the need for policies to bolster financial stability and promote growth. The authorities, in contrast, were more optimistic, believing that financial sector reforms would provide a significant boost to growth in the period ahead.

Text Table 2.

Mexico: Baseline Medium-Term Projection

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

Mexico: Productivity, Potential Output, and Medium-Term Growth

Mexico has experienced sharply different growth episodes since 1960, with GDP increasing at an average rate of 6½ percent during 1960-79, falling to only 2½ percent during 1980-2003. This raises the question of the factors underlying historical GDP growth in Mexico, and the implications looking ahead. We use an aggregate production function to decompose growth into its cyclical and trend components, and explore alternative medium-term growth scenarios (the analysis is described in more detail in an accompanying selected issues paper).

A. Growth Accounting

The growth accounting exercise is performed over the 1960-2003 period, assuming a Cobb-Douglas production function with shares of labor and capital of 67 and 33 percent respectively. Capital is derived from national accounts data on gross private investment using the perpetual inventory method, with an assumed depreciation rate of 10 percent. The labor input is defined as the economically active population aged 15 and over. Total factor productivity (TFP) is derived as a residual. Box Table 1 shows the resulting contributions of the three factor inputs from 1960 to 2003. From 1960 to 1979, real GDP grew at an average rate of 6.5 percent, while TFP rose by 2.1 percent. From 1980 to 2003, however, real GDP growth slowed to 2.6 percent. Most of this decline is explained by lower TFP growth—indeed, the level of TFP declined at an average rate of 0.5 percent over this period. While the performance during the more recent 1996–2003 subperiod is somewhat more favorable, with trend TFP showing a mild increase, the outturn still seems modest relative to the structural changes that were implemented, including significant trade and financial liberalization.

Box Table 1.

Mexico: Sources of Growth, 1960–2003

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Sources: INEGI and Fund staff estimates.

B. Medium-Term Projections

Our medium-term projections assume that growth in the capital stock is consistent with keeping the capital-output ratio constant at 1.5. As a result, the capital contribution is higher as we move from a low to a higher growth scenario because more investment is needed to maintain the fixed capital-ratio with faster growth. The labor force grows by 2.4 percent, and baseline trend TFP growth is assumed to be 0.3 percent. The latter is above the average pace since 1980, but below that in the 1960s and 1970s. It is also below the 0.7 percent rate experienced in 1996-2003, based on the assumption by staff that growth was temporarily boosted during that period by the effects of NAFTA and other structural reforms. We derive potential output as the sum of trend TFP and the contributions of capital and labor inputs. Based on these assumptions, projected GDP grows at an average rate of 3.2 percent during 2005–09, while potential output grows by 2.9 percent (Box Table 2). The difference reflects the unwinding of the output gap estimated to exist in 2004. The alternative “high” scenario shows the TFP growth rate that would be needed to support GDP growth of 4½ percent—the mid-point of the two PRONAFIDE growth paths constructed in 2002. The implied TFP growth rate of 1½ percent appears optimistic given the historical experience. The “low” scenario extrapolates the 1980-2003 record of declining TFP, resulting in GDP growth of only slightly over 2 percent.

Box Table 2.

Mexico: Medium-Term Growth Projections 2005–09—Alternative TFP Growth Rates

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Sources: Fund staff estimates.

Medium-Term Growth Forecasts

Citation: IMF Staff Country Reports 2004, 419; 10.5089/9781451825633.002.A001

Source: Mexican authorities and staff estimates.

IV. Policy Discussions

A. Fiscal Policy

21. The authorities reiterated their commitment to achieving deficit targets, noting that success in this area had underpinned policy credibility. Deficits based on the traditional definition had been kept close to the 2002 PRONAFIDE targets in recent years, despite political pressures for greater spending.6 For 2004, the budget figure of 0.3 percent of GDP for the traditional deficit remained realistic, as possible shortfalls in non-oil revenues and spending overruns would be more than offset by high oil revenues. Indeed, they felt it would be possible to save some of the latter in the form of a transfer to the OSF. The authorities noted that spending beyond budget estimates in 2003 (and probably again in 2004) resulted largely from adjusters that allocated windfall oil revenues to public capital spending, or covered increased costs in the public sector associated with higher energy prices.7 Thus, spending in these areas would automatically compress if oil prices were to fall.

22. Staff agreed that the authorities had established a strong reputation for fiscal prudence as a result of the sustained achievement of deficit targets. Concern was expressed, however, about the role that high oil revenues had played in meeting these targets in recent years in the face of non-oil revenue shortfalls and spending overruns. In the event, little of the excess oil revenues would be saved in the medium term, which appeared to contradict the spirit of the budget adjusters as originally envisaged. However, updated information shows that the authorities expect substantially higher savings of excess oil revenues in 2004 than suggested by the staff estimates, part of which will finance later investment spending (Text Table 3).8 While higher spending was partly due to the operation of the adjusters and higher energy costs, overruns in current spending exceeded the amounts attributable to these factors. Staff observed that the budget figures exhibited a pattern of overestimating non-oil revenues, while underestimating nondiscretionary expenditures. This provided room for congress to include more programmable spending in the budget, even with a low oil price assumption—excess oil revenues could then be used, in effect, to finance programmable spending. Due to spending of excess oil revenues, the fiscal impulse in 2004 was expected to be slightly stimulative, implying a pro-cyclical stance given the recovery underway.

Text Table 3.

Mexico: Saving of Windfall Oil Revenues

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On a gross basis. The net revenue impact would be partially offset by higher fuel prices for public enterprises and higher prices for imported gasoline.

Sources: Authorities and IMF staff estimates.

23. Staff emphasized the need for a framework that would promote greater medium-term savings of excess oil revenues. This was needed for three reasons: to avoid inefficient spending at times of high world oil prices; to reduce fiscal dislocations that could result from a drop in oil prices; and to take advantage of favorable conditions to reduce public debt. Staff recommended incorporating an objective assumption for oil prices in the budget (for instance, based on futures markets), and explicitly earmarking a significant portion (at least one half) of the difference between the oil revenues associated with this price and an assumed long-term price for saving—preferably in the form of a lower traditional deficit, given the attention paid to this concept. Deviations through the year between actual and assumed prices would then be subject to the same savings rule (possibly via transfers to/from the OSF). Such a framework would have two advantages. Firstly, explicitly incorporating saving of excess oil revenues in the target for the traditional deficit could increase the political commitment to achieving these savings. Secondly, the savings would take precedence over other fiscal developments through the year, such as higher spending or shortfalls in non-oil revenues. The authorities, in contrast, felt that the tending toward a conservative oil price assumption still played a useful role in containing spending pressures, and thus was more likely to deliver the desired fiscal restraint. They also did not believe that a different mechanism of adjusters would offset political pressures to spend excess revenues. They agreed, however, that the operation of the adjusters had left only modest scope for saving oil revenues. Looking ahead, they were hopeful that the OSF would accumulate a meaningful surplus if oil prices remain high.

24. The mission welcomed the revision to the authorities’ medium-term fiscal framework in the 2004 budget, and their intention to update it in the 2005 exercise (Box 3).9 Staff observed that meeting the objective for the augmented deficit of about 1½ percent of GDP in 2007 would require an estimated 1½ percent of GDP in net consolidation measures, assuming a mild easing in world oil prices.10 This would be particularly challenging in the absence of tax reforms that would raise new revenues, and in the face of medium-term spending pressures in the areas of health, education, and pensions. The authorities agreed that important fiscal challenges lay ahead. Tax reform remained on the agenda, although, even if passed, it might not raise significant new revenues at the federal level.11 This underscored the need to continue efforts to raise the yield from the existing tax structure, implement pension reform, and compress spending in noncritical areas.12 They noted that Mexico had a track record of cutting spending when required to meet deficit targets, and that this option remained available. Staff agreed that spending compression had allowed past budget targets to be met, but noted that the last instance of significant cuts was in 1998. The authorities argued that, notwithstanding the changing political environment, there remained a strong consensus for prudent policies in Mexico.

Mexico: Medium-Term Fiscal Scenarios

The 2004 budget updated for the first time the authorities’ medium-term fiscal framework, and it was revised again in the draft budget for 2005. The original version, presented in the 2002 PRONAFIDE, linked the pace of fiscal adjustment during 2002-06 to progress in structural reforms. With only modest reforms, the augmented deficit was to fall from 4 percent of GDP in 2002 to 1.6 percent in 2006, bringing down net public debt by 2 percentage points to 41½ percent of GDP. This program has gone off-track, however, as the augmented deficit is expected to reach 3.1 percent of GDP in 2004 vs. 2½ percent of GDP in PRONAFIDE. Public debt edged up through 2003, as a result of the higher deficit, low growth, and peso depreciation.

The latest framework maintains the original deficit targets for 2006, while underscoring the need for fiscal reforms. The adjustment effort is now concentrated in 2005–06, however. The traditional balance improves by ½ percent of GDP over these years, and off-budget financing is projected to fall by 1 percent of GDP. Based on a strong growth outlook (average GDP growth of 4.1 percent in 2005-08) but a low oil price assumption (US$20.8 per barrel for the Mexico mix), tax reform is seen as necessary to meet these objectives. The scope for spending reductions is limited; new pressures for social spending are foreseen (estimated by staff at 1½–2 percent of GDP); and the government is expected to service the debt of rising PIDIREGAS projects upon completion. In addition, the framework emphasizes the need for pension reform to prevent the pension bill from spiraling out of control after 2008. In staff s view, the framework’s reliance on reducing off-budget financing to lower the augmented deficit is problematic. The projection assumes financing only of existing PIDIREGAS projects, whereas a continued stream of new projects appears more likely.